The False Bargain of Passive Investing

Index investing started with John Bogle in 1975. Today Bogle’s Vanguard manages over $4.9 trillion predominantly in various passive products. It is ironic that a man famous for not market timing an investment portfolio, perfectly timed the launch of passive investing to coincide with an intellectual explosion in financial economics that passionately supported his pioneering passive investing products. Today the irony continues, as the intellectual foundations in financial economics that underpinned Bogle’s incredible success are much less robust than they appeared in the early 70’s, yet the push for passive investing is stronger and more fervent than ever. For proactive, process-oriented, intelligent advisors this will create a great opportunity to distinguish yourself from the growing herd of “commodity” advisors who preach little more than fee minimization, rather than alpha generation or negative alpha avoidance. The bargain such advisors believe they reach with their clients is by investing in index products, clients will get a low cost and fair return, avoiding the unpleasant advisor/client conflicts arising when active strategies underperform passive strategies.

This bargain rests on what has become an accepted “truth” that beating the market is typically the result of luck, therefore, investors should not pay higher fees to investment managers that are just lucky. The corollary to this “truth” is that broad indices provide a “fair” return. But what if passive strategies do not provide a fair return? After all, at the end of the day indexes are nothing more than managed portfolios. Let us explore how skillful the committees or rules responsible are for two of the most popular passive index products, The S&P 500 and The Russell 1000 Value Index and compare those results to Applied Finances broader mandate strategies, The Valuation 50™ and The Valuation Delta™.

The Rise of the Index

Before evaluating whether a “fair and square” deal results from passive index investing, let us first review the intellectual foundation for passive investing. Two theories from finance, when combined, created the wonderful primordial stew from which passive investing evolved into the single most dominant application of financial theory.

1. Capital Asset Pricing Model (CAPM)
2. Efficient Market Hypothesis (EMH)