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Passive vs. active investing

It's entertaining to read interpretations of the stock market's ups and downs in the financial papers. Reporters attempt to explain the market's arbitrary movements, whether large or small, as if there were a connection between stock trades and a speech by Alan Greenspan or a cloudy earnings forecast issued by a big tech firm.

Forget about trying to make sense of day-to-day moves in the stock market. It is an amorphous beast. Yet many investors lend it anthropomorphic qualities, believing it to be a rational being. Some subscribe to the "efficient market hypothesis," which holds that investors can't expect to beat the market consistently on a risk-adjusted basis.

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The reason: Lots of market participants have access to free, abundant, up-to-date information, and transaction costs are low. This passage, found in "Investments," an introductory textbook by Herbert Mayo, explains further:

"Since security prices incorporate all known information concerning a firm, the current price of a stock must properly value the firm's future growth and dividends. Today's price, then, is a true measure of the security's worth. Security analysis that is designed to determine if the stock is over- or underpriced is futile, because the stock is neither."

Oh, really?
Anyone who was alive, alert and attuned to financial news at the end of the 20th century will question the premise of that theory. Remember the distortions of 1999, when dot-com stocks with no earnings in sight rose exponentially?

I remember taking a long hard look at one of my holdings, the oxymoronic Firsthand Technology Value fund. It had ballooned from about a $2,000 initial investment in the mid-1990s to more than $9,000 in March 2000. I considered selling it, and then dismissed the idea, thinking, "Let's see what it can do from here."

Here's what it did: It fell into a deep, dark abyss. If the market has human traits, then it is psychotic, a manic-depressive.

Indexing -- a smart strategy?
Well, tech-sector funds fell harder than the broader market, which also took a beating, falling nearly 40 percent between 2000 and 2002. But over longer stretches, the stock market has rewarded investors to the tune of an 11-percent annualized gain on average.

Financial writers frequently advocate investing in index funds that mimic the stock market, rather than in actively managed funds that try to beat the market. Most commonly mentioned are funds that track the Standard & Poor's 500, a composite of 500 large American companies. It is the bogy against which large-cap domestic stock fund managers compete.

Most managers find it a formidable benchmark to beat. One fund manager who used to bend my ear spoke derisively of the S&P 500 as an index created by mere journalists. Duncan Richardson, who runs Eaton Vance Tax-Managed Growth fund, maintains a slight edge over the index, outperforming it by 0.75 percent a year over 15 years, according to Morningstar. That's not a heroic feat, but something to brag about nevertheless.

"I think his fund's record demonstrates how difficult it is to beat the S&P 500 by a wide margin over the long term, even for an experienced manager running a fund with a low expense ratio," observes Greg Carlson, fund analyst at Morningstar.

Carlson is among indexing enthusiasts who argue that the passive strategy enables you to diversify among a broad cross section of companies across several different industries at a low cost.

"Cheaply priced index funds have a significant long-term advantage over many of their actively managed competitors," he says. "Also, index funds don't require as much homework before purchase, and they typically eliminate concerns about manager changes, which happen frequently at many actively managed funds."

Not a static list
Nevertheless, idealistic investors seem to prefer betting on managers who might beat the benchmark. Only about 12.5 percent of exchange-traded and mutual fund assets are invested in passive index funds, according to Morningstar.

But the strategy is not as passive as you might think. The S&P 500, determined by a committee headed by David Blitzer at Standard & Poor's, is not a static universe of companies. It changes, with new companies added and old ones deleted, on a fairly regular basis. Some 150 companies have changed in the composite since January of 2000. That represents a transformation of nearly one-third of the index components in the last five and a half years.

-- Posted: July 13, 2005




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