Enrich Your Future 20: Passive Investing Is the Key to Prudent Wealth Management

Andrew Stotz 00:01
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry stands out because he bridges both the academic research world and practical investing. Today, we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And this is an interesting chapter. This is chapter 20, and it's called a higher intelligence. And what's interesting about this one is Larry's going to set up a scene, and in that scene, he's going to tell us a little bit of he's going to set a scene that's going to help us to try to understand how we should be thinking about the way we think about investing and prudence in investing in the like. So Larry, take it away, right?

Larry Swedroe 00:53
So the story is about a group of higher beings, an advanced intelligent society out there in space somewhere, and they're monitoring the radio waves and other forms of communication from earth to see how these lower beings on Earth are progressing in the society. And they became very interested in a specific set of communications related to popular theories that were being espoused about how you should invest, that people were trying to pick stocks and time the market, and it was kind of going against all the evidence that they had known for centuries, and even the evidence of the people themselves who were engaging they were persistently underperforming the market because of their strategies of actively trading, trying to pick managers, when all the evidence said, that's a loser's game. And they kept watching, you know, what was going on, and they felt compelled to come visit, to investigate this strange investment phenomenon, and they arrived at the New York Stock Exchange. They watched CNBC and Bloomberg and trying to figure out what's going on. And they're very disappointed that people are following these strategies, which we know, Andrew, you and I, at least know is a loser's game. Not that it's impossible to win, but the odds of doing so are so poor, it's simply not prudent to try. So the visitors decided, maybe there's some hope here for the humans, at least one of them. So let's go check the library to see what the laws say. And they were encouraged by what they found when they read something called the third restatement of trust, written in 1992 which is written by the American Law Institute, and it laid out very clearly what you and I know and I presented in my books, that all the evidence suggests that While it is possible to beat the market, there is no evidence that past performance is a predictor. You're taking unnecessary idiosyncratic risk, which are generally not rewarded. And the markets are highly efficient and becoming more efficient as research uncovers anomalies and once they get discovered and are published, then the anomalies, certainly, if they're behavioral in nature, will tend to shrink, if not disappear. And then they found a particularly interesting set of quotations from a professor named Michael share from the University of Minnesota's Carlson School of Management. And I need to read this because very specific. I think it's just absolutely brilliant analysis. He says ethical malfeasance occurs when an investment manager does something deliberately or conceal seals it like he knows he's drunk, but he drives anyway. For example, consider the manager who invests intentionally at a higher level of risk than the client chose without informing them, and then generates a subsequently higher return. The manager attributes the alpha or the excess return to his superior skill instead of the reality which he was taking more risk, so it was just more exposure to beta, not Alpha. Okay, then he says at the malfeasance occurs when a sorry, ethical misfeasance now occurs when investment does something by accident. The manager really believes he's sober, but he's not, and he drives. Thus the manager doesn't know what he's doing and shouldn't be managing money. Share concluded this managing money and. An efficient market without investing passively in index funds, or what I call funds, that are systematic, transparent and replicable in their strategies. So they're unique in how they define their universe, but once they define the universe, there's no individual stock selection or market timing. He then noted not knowing that such a market is efficient his investment misfeasance, because you should know it. It's in the law books. You don't even have to read the investment research. Just go look at what your duty as a trustee or you are, you know, managing money in effect, with that responsibility. In either case, he says he believed that such conduct may be imprudent. Per se, there's no excuse for the manager driving whether he thinks he's sober or not. The bottom line is share felt that passive investing this systematic, transparent and replicable strategy is the more ethical way to go. So these higher beings read this and feel comfortable that at least there's good directions and humans, over time, will figure it out. And the good news. Instance, I first wrote that story in the early 2000s the market has shifted dramatically. At the time I first wrote that story in one of my books, the market was maybe 10 or 15% invested in this more prudent way, and today, the estimates are maybe 50% or even more than that. So humans are waking up and maybe even the majority of the money, or close to it, is now managed in that systematic way.

Andrew Stotz 06:47
Yeah, so misfeasance has to do with, uh, improper or careless performance where you

Larry Swedroe 06:54
don't know what you're doing. It's an accident malfeasance, you know, it's bad and right? And I would suggest that most investment advisors who engage in active management surely by now know that it's malfeasance well.

Andrew Stotz 07:10
And if you combine that with yesterday's class I did at my university about the CFA code of ethics, we have responsibility for diligence and thoroughness in our research, which would mean that to claim misfeasance that you didn't understand or know something would not be acceptable under the CFA code of ethics, because you have an obligation to understand that. And as a prudent investor and as a person who's also, let's say, representing the interests of others, you have a certain obligation to do the diligence you know that gets you to those understandings before you take action.

Larry Swedroe 07:43
Yeah, what every active investor has to admit is you're taking on significantly more idiosyncratic risk, for which, if markets are efficient, you're not compensated for, because you'll have a concentrated portfolio. So what that means your potential dispersion of outcomes has fatter tails. You do have the opportunity to get greater than market kind of returns, but you also have the opportunity to have much lower returns. And the evidence on active investing is the managers that tend to outperform on average, outperform by a little bit, and the ones that underperform tend to underperform by a lot. Either they don't have the skill and they have higher expenses, and the ones who have who have skill enough to beat the market, most of that skill is offset by their higher expenses. So it's really still incredibly hard to generate alpha.

Andrew Stotz 08:43
And what can you recall, what you think would be the best research on the impact of fees that you've seen like, what is there? Is there a person that's associated with that? I'm looking at different papers and thinking about that, but I'm

Larry Swedroe 08:58
trying to think there are tons of papers on that there. Russ wormers did a paper early on in the 90s that I cited in my first book, if my memory serves. He found that the average active fund on a after underperformed, because even though the stocks that they picked out performed by roughly 70 or 80 basis points, right, their transactions cost was like 70 basis points, their fees were 80, and they're sitting on cash, which is an opportunity costs, on average, if the market gets 10% and T bills are, say three or four, you're losing that right? So there's a cost for sitting on five or 10% of your portfolio might be in cash. So those three costs meant that even though you had skill and you were generating eight. Basis points of gross alpha, your net alpha, which is the only kind that investors get to spend, was minus 160 on average.

Andrew Stotz 10:11
Yeah, and I see in the Journal of Finance, his article came out in 2002 mutual fund performance and empirical decomposition into stock picking, talent style, transaction costs and expenses. Yeah, there's

Larry Swedroe 10:23
another. Ken French did another major study later, maybe around 2010 and found something like 70 basis points and expenses. Trading costs, another thing. So you know, you have to overcome all of that, you know. And so investors will literally leaving 10s of billions of dollars every year on the table, and that money is going to the fund sponsors, the brokers you know, and the market makers who are shaving off those bid offers. And now you could add high frequency traders who are picking you up. Yeah.

Andrew Stotz 11:01
And one last thing I would say is just that, let's say a question I would ask is, are there times that active management can work? I guess one question you could say is, if a fund management company could build up a size that's big enough that the fee can get closer to a passive fee, possible? Yeah, so

Larry Swedroe 11:23
here, first of all, in aggregate, it's virtually impossible for active managers to win, because all stocks have to be owned by somebody, and if one active manager outperforms, because they overweighted outperforming stocks, that must mean that other active managers underweighted it, because the passive investors in aggregate, own the market pro rata, right? So it's impossible. Now we know that the markets are not perfectly efficient. In the warmer study, he found about 80 basis points of stock picking skills now that I believe today would be a lot lower. Why do I say that? Because coming out of World War Two, 90% of individual stocks were owned by individual investors. So Warren Buffett's of the world and the bright fund managers had a lot of dummies they could exploit and outperform over time. What we obviously are going to see are you have two groups of investors who are trying to beat the market. Andrew, you have the ones with skill and the ones without skill, right? Which group of investors are likely to abandon the efforts of trying to beat the market because they see their results at the ones without skill, with ones without skill, right? So they drop out, which means the remaining competition must be getting easier or harder, harder, harder, because you don't have the dummies to exploit. And today it's only about 10% of the trading is done by the naive retail investors, so you don't have a lot of them to exploit on top of them. When I got out of college and was looking to become a security analyst. Very few of those people had degrees in finance, because I actually graduated with one of the first degrees in finance, because there was no finance theory until the late 60s and early 70s, William shop and others created the CAPM finance was taught maybe in an economics program or an accounting class, and they finally became a profession in the 70s and 80s, and you had MBAs in finance. So today, everyone who manages money virtually has an MBA or a PhD in finance or physics or more. They're rocket scientists, literally, I mean that, and they have access to far more databases, and, you know, high speed computers, and so the competition is incredibly harder, yeah, so I think it's getting much harder because the supply of victims has come down, and the people who you're trying to be Warren Buffett is no longer competing against the Larry swedros of the world. He's competing against the citadels like Ken Griffin and Renaissance technologies. That's who do you know, the vast majority of the trading. So here's what I would say. I still believe that there are likely some people with enough skill to generate gross alpha, just super smart and access the databases everything else. Clearly, some of these high frequency traders in the citadels are all they're doing it, but they're more doing it by shaving pennies off of each trade. And they do. You know, 100,000 trades a day, often, but if you get your cost low enough, then maybe you can generate alpha. So I've done, I haven't done this in about 10 years because the SEC stopped allowing it. I used to look at do a study of all the major fund families, one at a time, and took their biggest active funds, benchmarked them against a five factor model, and compared them then to the funds like dimensional fund advisor, which is systematic, transparent and Vanguard Index funds. And I found only one single fund family that managed to generate alpha once you adjust it for factors, and it was Vanguard's active funds. It wasn't statistically significant, their out performance, and it was very slight, but they're able to do it because their average cost and their active factors were in like the 20 or 30 basis points, not 80 100 or or more, right? So, yes, if you can get in other words, let's say at this active management does not fail because it's stupid. It fails because of costs. And the market is super efficient, but not perfectly. So, yeah, so there's nothing that prevents the active managers, say a Vanguard, from doing the same things that the dimensionals and aqrs of the world do, like, avoid buying stocks that are indices, but the research shows are bad, like Penny stocks, stocks and bankruptcy small cap growth stocks with high investment and no profits, and they can trade patiently instead of demanding liquidity, cutting their market impact. So if you do all those things, you got a much better chance. But even then, you're not likely to win by much. So I think investors are better off avoiding it. But if you're going to use active managers, you want to use fund families like Vanguard, that does two things. One, they're systematic. They don't stray. If you're buying a Value Fund, you won't find them buying growth stocks, so something like Wellington and they have low costs and low turnover, so they look like Warren Buffett, if you will.

Andrew Stotz 17:31
Well, what a great way to end. I mean, we started this. This section is part two of your book, strategic portfolio decisions, and we ended on a clear note about using passive rather than active in almost every case, it makes most sense. Remember that part one was how market how markets work, and now we're going to be moving into part three, which is behavioral finance. We have met the enemy, and he is us. And I'm really looking forward to chapter 21 which has a great title you can't handle the truth.

Larry Swedroe 18:05
Great with Jack Nicholson's famous and maybe best line of his career. Yeah?

Andrew Stotz 18:10
What a great. What a great. A great show. Good

Larry Swedroe 18:13
men for those who don't recognize that line, yeah, check it out. Great. Exactly,

Andrew Stotz 18:18
exactly. Larry, I want to thank you again for another great discussion about creating, growing and protecting our wealth. For listeners out there who want to keep up with what Larry's doing, find him on Twitter at Larry swedro. You can also find him on LinkedIn. This is your worst podcast. So you got something you want to add?

Larry Swedroe 18:33
Larry, yeah, I just wanted to add something for those who want to follow me. You can go on X or, you know what used to be Twitter and LinkedIn, and I just posted, I think, a really wonderful podcast that I did with Adam Butler from resolve and Pierre Dali, and we spent an hour and a half going over some really important And interesting topics. So I highly recommend listening to that podcast for your listeners and even you. Andrew,

Andrew Stotz 19:05
yes, I'm going to listen. And I saw that you posted that, and I'm going to put a link in it in the show notes, so feel free to click on that, and let's listen to that. This is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.