The rise of passive investing, which its advocates prefer to call low-cost investing , is the most dominant trend in the markets during the past decade. Sure, exchange-traded funds (ETFs); smart beta; factor investing; environmental, social and governance (ESG); impact investing; and other themes have all attracted adherents. But if we were forced to select the single biggest stylistic change in investing since the financial crisis, the embrace of low-cost indexing would likely be the one.
The problem that confronts us is the criticism that indexing is worse than Marxism, is devouring capitalism, is a lobotomised investing style that creates a “frightening” risk to markets. Or so we are told. Mostly what the articles I have linked to show is the risks not to investors but to the people who earn a living selling high-cost, underperforming investment products.
Today, we shall apply Charlie Munger’s aphorism of “invert, always invert” to the active-versus-passive management debate. Set aside your biases (I’ll try as well), and assume that these folks are correct, that indexing is evil, and that investors should embrace active management for at least part of their portfolios.
What might that look like?
Begin by considering the advantages of active over passive. At this point, we are all so well aware of the disadvantages of active that it would be redundant to repeat them all here.
Active management offers the promise of several desirable goals versus passive, including:
• Alpha: outperformance versus a benchmark or market rate of return.
• Expressive: investing toward a specific goal that isn’t primarily financial in nature.
• Risk management: controlling results by managing around market, sector, stylistic and other risks.
• Behavioral: affecting decision-making by investors.
Let’s consider each in turn.