Between 1876 and 1941 there were 28 Major League Baseball players who batted +400 in a season (according to Wikipedia!).
From 1942 to 2018 there have been zero. In the seventy-six years that have passed since Ted Williams achieved that feat, not one single major league baseball player has hit +400 in a season. And only three players have even come within striking distance.
It would be a real stretch to say that I am a baseball fan. But I don’t need to be a baseball fan to know that something must have fundamentally changed within the game of baseball. So how does that relate to investing?
The parallel is the shrinking amount of outstanding active managers and the zero-sum game theory.
The Zero-sum game theory is the central concept that underlies the case for index investing. The theory states that the market consists of the cumulative holdings of all investors.
Since the market return represents the average return of all investors, for each manager that outperforms the market, there must be another manager that underperforms the market by the same amount.
Because it’s a zero-sum game, the aggregate excess return of all managers equals zero (it’s actually less than zero when you add in the management fees). If the theory is true, the wise investor would logically invest in a simple basket of securities and use the lowest cost option to do it – as there is no theoretical alpha to be captured.
We would argue that the theory is true, but it fails to address the reality that dumb money does exist in the marketplace. There are investors who consistently make poor investment decisions (see Growth Bias). And good active managers should be able to capitalize on the poor decisions of weak investors.
Regardless of your view on the Efficient Market Theory, the case for passive investing is growing.
This is essentially a self-fulfilling prophecy!
Without a large number of investors making bad investment decisions, it is very difficult for active managers to outperform.
“If you ever sit down at a poker table and don’t know where the dumb money is sitting, you’d better get up, because it’s probably you!”
Warren Buffet recognized this concept over twenty-five years ago when he said: “By periodically investing in an index fund… the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
Even the FINRA website states: “Simply put, as a group, actively-managed funds, after fees have been taken into account, tend to underperform their passive peers.”
Source: Source: Capital IQ, BAM Alliance, Telos Asset Management
And it’s not just actively managed mutual funds that are struggling, the entire hedge fund universe is struggling. Between 2009 and 2018 the HFRX Global Hedge Fund Index (an index designed to represent the overall composition of the hedge fund universe) delivered a whopping 1.5% annualized net return to investors.
Actively managed funds are underperforming and shrinking while money is flowing into passive funds, and that is not a coincidence!
On 9/11/19 Bloomberg published an article that stated passive equity funds have finally eclipsed “old fashioned” actively managed funds. Over the same period that passive funds outperformed the actively managed universe, low-cost ETFs have doubled their market share and now represent the lion’s share of the fund universe.
As the passive funds have grown to dominate the investment landscape, the available alpha has been getting squeezed out of the market because there are less weak investors for the smart money to prey upon.
The dumb money has essentially responded to Warren Buffet’s challenge twenty-five years ago and ceased to be dumb money.
Where investors may be missing the mark is in what should be painfully obvious: If the lion’s share of the fund flows is going into passive funds that are investing in the same assets, it will naturally drive up the price of the underlying assets in those funds.
HIGHER DEMAND LEADS TO HIGHER PRICES!
This is also a self-fulfilling prophecy. It should be no surprise that passive investing will outperform active investing when all the asset flows are going into passive funds. Higher demand naturally drives higher prices.
In the same respect, the current momentum that is being captured on the upside when all the money is flowing into passive strategies will be captured on the downside when all the investors investing in passive funds (that own the same underlying assets) head for the exit sign at the same time.
Passive investing works well when everyone is piling into it, and it’s likely to work just as poorly when everyone heads for the exit sign in the next major market downturn.
To be clear – we are not saying the investors should avoid using low-cost ETFs. We think they should, because the market is becoming more efficient.
But investors who recognize the advantages of low-cost ETFs should also recognize their limitations – because the investors who avoid the underlying assets in the passive strategies in the next market downturn are likely to be the ones who outperform.