STREET DOGS

From Larry Swedroe at The Evidence-Based Investor:

That active management is the winning strategy in socalled inefficient markets is one of the great lies, perpetrated by Wall Street and some of the financial media.

As proof, all one has to do is look at the results of the S&P Dow Jones Mid-Year 2019 SPIVA (active versus passive) Scorecard. For the 15-year period ending June 2019, 90.3% of all actively managed small-cap funds and 94.3% of actively managed emerging market funds underperformed their benchmark index. That’s worse than the 87.8% of all [US] fund managers who failed to beat their respective benchmarks, and even more than the 89.8% of all large-cap [US] fund managers who failed.

The explanation for why active managers in emerging markets and small-cap stocks have done so poorly is that markets that are less informationally efficient are characterised by lower trading volumes, resulting in less liquidity and greater trading costs.

Based on the evidence we have from the “inefficient” smallcap and emerging markets, any advantage gained as a result of informational inefficiencies is more than offset by an increase in trading costs. Remember, to generate alpha, the costs of implementing an active strategy must be small enough that market inefficiencies can be exploited.

Another explanation for active managers’ poor performance is that perhaps emerging and smallcap markets are not as informationally inefficient as Wall Street wants you to believe.

Passive investing doesn’t win because active managers are dumb. As John Bogle points out, you don’t need the markets to be efficient for passive investing to be the winning strategy. It’s the greater costs of active management that are the cause of its underperformance.