In the active versus passive section it is proven that the return to the average dollar managed passively equals the return to the average dollar managed actively before any cost is extracted. It followed from this that if the cost to the average dollar managed passively is lower than the cost to the average dollar managed actively, the after-cost return to the group of passive participants is always higher than the after-cost return to the group of active participants. This is certain in every time-period measured. Some of the active participants will outperform. This is offset by underperformance from other active participants.
Why then are market participant’s portfolios full of actively managed products?
The short answer is that it is amazing what can be justified when one’s livelihood is at stake.
The longer answer has nuance. Read a brief history of investing in Canada. Here is a shorter version. There was a time when the middle class had access to only GICs for savings vehicles. The mutual fund changed this and provided the middle-class access to stock and bond markets. The industry boomed, and clients benefited. All funds were actively managed with large performance drags. But they were still able to outperform the returns offered by low risk, low return GICs.
Then came along research that proved that active management delivered negative value. As a group, active managers underperformed their benchmarks after-cost. The passive investment management industry was born. Most firms offer passively managed products now. Some companies such as Vanguard started exclusively with passively managed products and have since added actively managed product. Yes, it gets confusing.
Why isn’t passive management better understood, even by market professionals? Some do understand. Warren Buffet, and many others, have stated most investors are better served investing in indexed products. Many refuse to accept the logic. (Note the date on the article by the Nobel prize winning economist.) Many accept the logic but insist they will be part of the small portion that outperforms the benchmark before and after-cost over the long-term. This may be due to human nature. We all think we are better than we are at what we do. Poor investment performance can be self-explained by bad luck or one unwise decision. Next year will be better.
Why isn’t passive management better promoted? Few have an economic interest in full promotion of the superiority of passive management over active management. Livelihoods are at stake. A new business model would be needed. Advice would still have value and a new method for paying for the value would need creation. (It exists. The client pays the advisor directly instead of through the product.) Even the Vanguards and Blackrocks tread carefully promoting passive management. Most savings in Canada are managed through an advisor. Product providers consider the advisor to be a client in addition to the underlying client. Product providers want advisors to recommend their products. Even firms with the largest market share of retail passively managed products like Vanguard and Blackrock don’t want to anger advisors by questioning high fees and therefore advisor’s livelihood too much. They need the advisor.
Online brokers benefit when clients become do-it-yourself-advisors and open online brokerage accounts. But their ideal client is a frequent trader. The more the client trades, the greater the revenue to the online broker. Passive investment management is largely a buy and hold strategy and generates a low level of revenue for the online broker. The online broker welcomes the accounts of those following a buy and hold strategy, but they won’t be their most profitable accounts.
Other than the you, it isn’t in anyone’s massive interest for you to be your own financial advisor and invest in broad market, passively managed financial products. You are slashing cost and the cost centres aren’t thrilled.