Active VS Passive Investing

June 2021

 

 

“Both poker and investing are games of incomplete information. You have a certain set of facts and you are looking for situations where you have an edge, whether the edge is psychological or statistical.”

–David Einhorn, Greenlight Capital

“Anyone hewing to the benchmarks, which are backwards looking, they’re not about the future. They’re about what has worked. We’re all about what’s going to work.”

– Cathy Wood, Ark Invest

 

A few months ago I wrote an essay about the easiest to follow high impact investing strategy you can employ. Something that with virtually no effort or experience will pretty safely get you about 80% of the returns you can get from investing money in the stock market and getting a solid return. It’s the most widely recommended strategy by financial experts.

The strategy is to basically buy a broad stock market index fund so your return will be the general return of the stock market. Stock markets might go up or down sometimes but on average, it pretty much always goes up. And to choose an index fund that charges the least amount of fees so over time you keep the most amount of money.

But this got me thinking about what the opposite of that might be. If you knew a lot about finance, stocks and companies, how would you be investing? I do have an MBA afterall and the richest people in the world generally don’t keep all their money in index funds. They may keep some of it but generally they actively invest it in companies they think will succeed. This sent me down a deep rabbit hole on the many decades long debate between passive and active investing.

The best strategy I talk about in the other essay falls under the umbrella of “passive investing.” This means you don’t make any decisions with your investing, you buy 1 thing – the index fund – and then never have to think about it again. Whereas the other umbrella of “active investing” means you are thinking about what stocks to buy and sell all the time. You are actively choosing investments with the hope of trying to beat the return you would get by the stock market generally.

The biggest advantage that active investing generally has over passive investing, besides being able to employ unique strategies, is being able to attempt to time the market by buying and selling positions based of your own research. The common axiom from Benjamin Graham that “time in the market beats timing the market” applies moreso to passive strategies than active strategies. Timing is hugely important for an active investor or as Ray Dalio puts it, “timing is the most important consideration for asset allocation.”

Simplistically, in a year if the market goes up by 5% X 5 times in a year and the market goes down by 5% X 4 times in a year. If you’re passively investing to just follow the market, you make a 5% return for the year, catching all of the ups and downs. If you’re an active investor and can catch all the ups and miss the downs, you make a 20% return for the year. If you not only miss the downs but actively buy in the downs then you might make a 40% return per year. Conversely if you miss all the ups but catch the downs, you might lose 20% per year.

Or with real data, from 1979 to mid-April of 2020, the S&P 500 Total Return Index gained 11.23% per annum. If you missed the best 40 days of the stock market, returns shrunk to 5.21%. How about if you missed the worst 40 days? Your returns would soar to 18.83% annually. And importantly, if you missed both the best and the worst 40 days, you actually beat the market at 12.39%.

A phrase in investing that has always stuck with me is that losses are more impactful than gains. If your portfolio makes 50% and then loses 50%, you haven’t broken even, you’ve actually lost 25%. You need to make another 25% return just to get back to breaking even. Or another way of saying it, you need to be up 100% if you’re going to lose 50%, to start over again.

It’s more important for your overall returns not to lose money than it is to gain money. Which is one of the key advantages of passively investing – that it is much more difficult to lose money in passive index funds than actively managed funds because it’s much less risky. There is no individual stock risk, only broad market risk.

This is when you come across some important Greek symbol phrases in investing, Alpha and Beta. Delta exists too but that just means the change in different prices. From Investopedia:

“Alpha and beta are two different parts of an equation used to explain the performance of stocks and investment funds. Beta is a measure of volatility relative to a benchmark, such as the S&P 500. Alpha is the excess return on an investment after adjusting for market-related volatility and random fluctuations.”

Trying to beat the average stock market return is Alpha and the amount of risk you experience while trying to do so is Beta.

Generally just buying and selling stocks is a low amount of Beta. Where the risk really starts to increase is when you get away from stocks and into options and derivatives, which are basically complicated bets on the price of a stock. One party makes or loses money if the price goes up, another party makes or loses money if the price goes down.

The consensus among financial experts is you shouldn’t buy and sell options or derivatives unless you really really know what you’re doing. Because the potential losses you can occur are infinite. With a stock all you can lose is what you invested. With an option, you could lose everything and then some. But there is also the potential for huge gains.

Keith Gill while buying call options on Gamestop in 2021 turned a $50,000 option purchase into $40 million dollars. He made money as the price of Gamestop went up. On that same stock, betting the price would go down and losing, Melvin Capital lost $5 billion dollars, with the group short selling the stock collectively losing $19 billion dollars.

Options and derivatives are probably the most extreme form of active investing. A less extreme example of active investing would be day trading where an investor will make dozens of buy and sell trades in a day to try and take advantage of price movements in assets during the day, making a little bit of money on each trade.

The least extreme would be what Warren Buffett’s firm Berkshire Hathaway does. Where they research and then buy individual stocks but they’ll passively hold that stock for decades, believing the price will go up as the business grows. Where the value of the individual stocks he buys will grow faster than the stock market, thereby creating Alpha.

Within the umbrella of active investors, there is a whole bunch of different strategies all trying to generate Alpha. In fact there’s an entire industry of investment fund management designed around trying to beat the market return. The biggest being hedge funds, mutual funds and exchange traded funds.

Generally all such funds are structured as limited partnerships or companies. Companies where the fund investors own shares or limited partnerships where the fund is a trust managing the money for investors who get partnership or trust distributions.

There are value investors like Peter Lynch of Fidelity or Warren Buffett of Berkshire Hathaway who try to pick a stock they believe is trading for less than the worth of the underlying business. Meaning that they believe the stock is mispriced and they generate Alpha by buying it and waiting until the market realises what they’ve realised. It usually means buying a lot of stock during downtimes when prices are cheap and selling a lot of stock in uptimes when prices are expensive.

There are activist investors like Bill Ackman of Pershing Square or Paul Singer of Elliot Management who will try to join the boards of public companies and petition them to make key business changes like replace CEOs or sell off badly performing assets. They generate Alpha by believing a company is being badly managed by its current executives and that they could steer the company towards new strategies that will make the stock perform better. After Pershing Square replaced the CEO of Canadian Railways with a better CEO, the stock grew 300%.

There are long / short investors like David Einhorn of Greenlight Capital or Michael Burry of Scion Capital who will do a ton of research on something before taking a huge short or long position on a stock or industry, often betting that something will collapse entirely. They generate Alpha when in the long term something becomes really scarce or in the short term when an industry collapses. An example are Burry buying up much of the water rights to an area right now when water is cheap, betting that eventually water will be scarce. Or Einhorn and Burry both shorting the big US banks during the 2008 housing collapse where both made fortunes when Lehman Brothers filed for liquidation.

There are global / micro investors like Ray Dalio of Bridgewater Associates or George Soros of Soros Funds who try to pick stocks based around global politics, world events and news cycles. They generate Alpha by successfully guessing big economic shifts like if Japan has negative population growth, housing demand will reduce thereby housing company stocks will go down. Or when the US goes to war it means that American weapons manufacturing company stocks will probably go up.

There are quant or high frequency investors like James Simon of Renaissance Technologies who use algorithms and computers to execute thousands of trades per second. They generate Alpha by using computers to automate complex tasks and then being the first to market. For example when an earnings report for a company comes out, the computer will read it faster than a human can, then an algorithm will determine whether they should buy or sell the stock. The computer does so and by the time the humans arrive, the algorithm has already made the trades. Doing this thousands of times a day makes a small amount of money each time.

There are contrarian, trend or growth investors like Cathy Wood of Ark Invest, or Thomas Price of T Rowe Price who believes the future is so unpredictable that many of the most innovative companies of the future will grow much beyond what people expect them to grow. They generate Alpha by picking the companies that will grow the most, much beyond what people expect. Woods invested in Tesla expecting it to become the biggest solar power company when it made cars while Price made a fortune in railways, seeing that railway would become the primary freight mover not just people mover.

There are bond or dividend investors like Bill Gross of Pacific Investment Management or Michael Steinhardt of Steinhardt Partners who buy up all the bonds and debts a company has. They believe that companies can be optimistic and under prepare for harsh times and over leverage themselves or borrow too much money. So you can make more money than you can on the stock by buying the debts of the businesses, so then when interest rates rise or businesses default on their loans, they can negotiate favorable payouts or stock deals.

What they all have in common though is they pick stocks and companies and implicitly they believe that the market is not always a rational place. Fundamentally active investors try to pick individual stocks while passive investors do not try to pick individual stocks. Passive investors fundamentally believe that markets are rational and that you can’t outperform the markets regularly. That over the long term everyone reverts back to the average.

This is called the efficient market hypothesis and is fundamental to the idea of passive investing. It’s an idea that the stock market is a rational place and that all information about a company are already baked into the price of a stock. That the price of a stock always reflects its fair market value and that investors are all making rational investing decisions, companies are all run rationally and prices move synonymously with information – therefore over the long term everyone will be average.

This idea explains that outperformers are not actually outperforming, they’re just getting lucky. That if every person tossed a coin 100 times, with a big enough sample size, a lot of people would get heads 100 times repeatedly. That billionaire exceptional investors are just lucky, they’re those people getting heads 100 times. Eugene Fama won a Nobel prize in economics for this research.

Personally I disagree with it. I think that humans as a category are known for making bad decisions. We are particularly good at overestimating and overpaying for things. When I was a kid I used to play a lot of Magic The Gathering, a trading card game. I remember first hand people constantly paying more for cards than their underlying value and being disappointed when the cards would be worth less than what they paid. I think that the existence of bubbles and booms is evidence that stock prices don’t always reflect reality.

The problem is that they’re both right. Most people who try and beat the market are not very good at it and actually can’t beat it. Something like 90% of all actively managed funds lose money and fail to outperform the general market.. While something like 97% of traders lose money and fail to outperform the general market.

All the evidence shows that the more often a person trades securities, the more money they are likely to lose. According to Etoro when these active traders lose money, which is most of the time, on average it is about 36% of their pool of capital.

It’s less than 10% of all investors who can consistently beat the market and make money investing. But the very small amount of fund managers and active investors who can beat the market, do so to such a degree that you wonder why you’d ever keep your money in an index fund and not just with them.

There’s a reason why all of the investors listed above are billionaires, they beat the market to such a degree that they’ve become billionaires. Last time I checked it was pretty difficult to become a billionaire. The reason is because the industry has a built in power law distribution in it. The best performers are consistently 10X better than the average performers.

When passive investing in an index fund, your general returns are 5% – 8% per year. But with the top active investment funds, they may generate anywhere from 10% – 50% per year. Berkshire Hathaway’s long term returns are around 20% per year. While Cathy Wood’s Ark Invest can be up 150% in one year and then down 30% in the next year. Or most will generate negative returns.

According to this study, over the last 15 years from June 30, 2003 to June 30, 2018, only one in 13 large-cap managers, only one in 21 mid-cap managers, and one in 43 small-cap managers were able to outperform their benchmark index. It makes the idea of a finance professional seem kind of like an oxymoron if the market beats 95% of them except only the top 5%.

The axiom seems to be that you should invest your money in one of the 5% star performers who beat the market. Or you’re better off keeping your money in an index fund. There isn’t really a middle ground as if you do anything other than those, you’ll probably perform worse than just the index fund.

How do you know if you’re one of the star performers? A litmus test is just to start investing and see if you’re able to beat the index funds consistently. If you can, you are. If you can’t, you aren’t. The market is transparent in such a way that you can’t hide your true performance.

Something I didn’t understand is if 95% of people in the industry are worse than the index. How does this industry even exist? Because very large investors are investing their money with these people for them to have active investment funds which is worse than just using the index fund. That’s when I realised, I think it’s the cost of doing business to find the star performers.

Big super funds and pensions and endowments and fund of funds, these are the investors in investment funds, have no idea which managers can outperform the market. But they do know that if they ever find one, that person will make them so much money. So they give small amounts to lots of firms to find which ones do. Then they triple down on the ones that do with lots more money. That’s why the funds management industry can exist even though 95% of participants are bad.

So what should you do? Unless you’re the next great investor or know them so they’ll let you invest in their company. If you want to actively invest to beat the market you could buy the individual companies of the active investors trading on the stock exchange. You can buy Berkshire Hathaway stock and become an investor in Warren Buffet’s fund or buy Pershing Square stock and become an investor in Bill Ackman’s fund or buy an Ark ETF and buy Cathy Wood’s fund. Thereby backing the individual start performer who’s strategy most resonates with you.

That’s the easiest way of passively actively investing, letting someone else do it for you. But probably investing in the index fund is still the best decision for most people. The problem isn’t necessarily which fund to pick, it’s that most people are not investing at all. Which is the worst thing they can be doing.

Personally, I actually like the Peter Lynch approach. He has a pretty simple framework for regular people to outperform the index funds and make money in the stock market while actively investing. It’s to just buy companies that you yourself are a user of and like.

The thinking goes that if you’re a consumer of a product made by a business, then you probably already know it’s a good business and therefore the stock will probably be a good one to buy. Because consumers are very discerning and know more about markets and products and trends than Wall St does because they’re the customers of these businesses. There’s no point in people buying stocks in industries or businesses they don’t understand, you should buy the stocks of the things you like.

So you can be a better investor by going to malls and shopping than by reading financial reports. If you really like the donuts made by a particular donut company, odds are that company is probably doing well by being able to make the donut you like. So you should buy the donut company stock. This isn’t even a hypothetical, one of Peter Lynch’s best investments was Dunkin Donuts which returned 30%+ per year over 13 years, completely destroying the returns from the index funds. Why did he buy that stock? He liked the donuts.

It’s not particularly complex which is why I like it. I’ve definitely started buying the stocks of businesses whose products I use and can confirm, I’ve outperformed the index doing so. Which is the professional active investing I like. I really like Domino’s pizza and the stock is up 25% since I bought it. My wife likes Lululemon sportswear which has similar outperformance. Who knows if that will continue, if the data is anything to go by, probably not. But I hope so. I like pizza.