How often have you asked yourself: is it worth me holding onto these Telstra shares my parents gave me? Is there a better option to earning such a paltry return on my savings? Does anyone know a good fund manager? Or what the hell are people talking about when they refer to “index funds” and “ETFs”? These questions are not only common, but reflect a deeper tension in wealth management. Whether you should be an active or passive manager of your capital. What follows is the first of a four-part exposé on this question. A subject upon which no shortage of professionals have had their say (A PDF version of the entire four-part series may be found here). Passive management refers to the buying and holding of a diversified pool of assets, which track the average market return. While active management denotes an effort to “beat the market” through skilled selection of financial securities. In brief, I’m bullish on capital allocation – be it active or passive – but bearish on this “great debate”. The contest between active and passive may serve as good fodder for journalists, but it relies on an artificially static view of the financial world. Instead, I propose a more dynamic theory of capital allocation – beginning with a broad survey and history of active and passive investing.
Active management is well known, having been popularised by the riches and exploits of financial titans like George Soros and Warren Buffet. Passive investing, however, is less well understood, having only originated with index funds in the 70s and propelled by ETFs in the 90s. In brief, an index fund is an investment portfolio constructed to mirror the average return of a specific basket of assets. It achieves this goal by weighing ownership of each underlying security according to its total market capitalisation. The fund then periodically adjusts its holdings according to the ever-changing market share of each financial asset. For example, say the listed shares of Xero Limited (XRO) were to increase over the course of this quarter, then so too would its proportionate share of the S&P/ASX 300 index or the All Ordinaries index. By adjusting its portfolio in this manner, an index fund inherently responds to movements in price rather than the underlying economic performance of an asset. Which means that index funds are prone to participating in financial bubbles and speculative euphoria, such as the dot-com boom of the late 90s and the sub-prime real estate bonanza of the 2000s. Index funds, nonetheless, require no professional effort to identify securities according to their investment merit. This means that management fees are much lower than active or professionally managed products. Index funds ultimately enable one to invest in a manner that eliminates the risk of underperforming the market, but also outperforming it. Instead, investors capture the average market return, at the price of a very low management fee.
Passive investors have two options. First, they may purchase units in an investment trust (also known as a managed investment scheme), which pools together investor capital to build a portfolio of an index. Alternatively, an investor may purchase shares in a publically traded Exchange Traded Fund (ETF). Both vehicles seek to track the performance of a predefined basket of assets. The key difference is that ETF investors trade with other market participants if they wish to increase or decrease their holding of the index. While a unit trust investor will transact solely with the fund manager, who then buys (or sells) a relevant number of securities to satisfy the desired contribution (or withdrawal) from the fund. ETFs also have a creation and redemption feature, which ensures that the ETF share price does not stray too far from the underlying market value of the portfolio (also known as the Net Asset Value or “NAV”). As a result, the ETF capital structure is not strictly “closed”, as is the case with many other publically listed funds. ETFs have become particularly popular among institutional investors, who wish to bet on broad market movements, while unit trusts have been the preferred choice of traditional retail investors. Both structures have unique operational attributes and offer different things to different investors. But for the purposes of this investigation, the most important thing to remember is that the performance of each vehicle is inherently tied to the return of the underlying basket or index of securities. In other words, they are different means of tracking the average return of a pre-defined asset class.
The first index funds were born out of theoretical models and ideas advanced during the 1950s and 1960s. This research was made available to a public audience in the 1970s, with the publication of Burton Malkiel’s landmark book: A Random Walk Down Wall Street. Malkiel’s underlying thesis was that, rather than picking professional fund managers or stocks, the average investor was better off just holding a portfolio of securities that tracks the market return. Around the same time, a man named John Bogle launched the first ever index fund and founded the Vanguard Group, which is now one of the largest passive fund managers in the world. If the case for passively managed index funds has been around for decades, then why the sudden uptick in debate? The reason is that, since the global financial crisis, all asset classes have been enjoying steady and increasing returns – from corporate bonds and equities, to sovereign debt and even Australian real estate. As a result, passive fund managers, such as Vanguard, have attracted record inflows and uptake of their indexing products. At the other end of the spectrum, active managers have suffered record outflows, as they struggle to outperform even the market index. Over the last 12 months alone, $US534 billion has flowed out of actively managed funds and $US442 billion has flowed into passive equity funds, globally. Even the world’s greatest active investor, Warren Buffett, has seemingly run out of ideas, as Berkshire Hathaway – his investment conglomerate – continues to amass an ever-growing pile of excess cash (around 100 billion USD). This broad and seismic shift of capital, from active to passive management, is the defining feature of today’s financial markets.
So why should this be of any concern to the average punter? It matters because if regular investors can achieve stellar investment returns without the helping hand of a professional (via a low-cost index fund) then it raises the legitimate question of what those active managers are getting paid for? Such professionals typically charge very generous fees for outperforming the market and even just for showing up to work. But if most of them can’t even outperform the market, how can they justify such lucrative fees? Accordingly, index funds have not only revolutionised the ability to access returns, they threaten the underlying value proposition of the entire wealth management industry. This includes everything from superannuation funds and private equity managers, to non-profit endowments and investment consultants. Needless to say, the community of active managers has been scrambling to defend their craft and professional fees. Some of this country’s most respected investors have disparaged the entire notion of passive management as “investing for dummies” and “lobotomised investing”. While others have warned the proliferation of index funds is inflating a new financial bubble. So, where does this leave the average investor? Should they steer clear of such “lobotomised” investing products? Or is passive management the preferred option? To answer these questions, we must delve into the theoretical foundations of both active and passive management.
The contest between active and passive is rooted in a deeper intellectual debate about whether financial markets are efficient or inefficient. Namely, whether asset prices inherently reflect or depart from the underlying economic value of an asset. Those arguing that financial markets are efficient, subscribe to a passive management approach. While those claiming that markets are inefficient adopt an active management approach. Even the Nobel Prize Committee appears to have split on this issue, having awarded the prestigious 2013 Sveriges Riksbank Prize in Economic Sciences to both Eugene Fama, the intellectual forefather of the efficient market hypothesis, and Robert Schiller, a key proponent of inefficient markets. Efficient market theorists contend that asset prices always reflect the underlying economic value of an asset, which makes it impossible for any investor to consistently beat the market return. They argue that asset prices always reflect the totality of available information and rational expectations of investors. In this sense, asset prices may only depart from value because of barriers to information or the cost of information gathering and analysis. One only has to observe the instantaneous movement of public equity prices to see proof of just how promptly investors react to every earnings release, industry statistic, or movement in interest rates. The implication of this theory is that investors may only seek to track the average market return; not outperform it.
Active managers, on the other hand, argue that investors are inherently emotional creatures and susceptible to herd-like behaviour. Asset prices, therefore, often depart from underlying value – sometimes dramatically – which creates opportunities to beat the market return. Such inefficient prices, they argue, stem from the inherent fluidity and subjective nature of economic value. Value is often defined as the sum of an asset’s discounted future cash flows – the key word being future. Since value is derived from events that are yet to happen, and which are inherently uncertain, valuation is necessarily tied to the imperfect assessments of investors. No matter how prepared, skilled or educated an investor may be, they can never be endowed with perfect knowledge of the future. Instead, they must draw upon their unique knowledge and skills to estimate a probabilistic range of potential cash flows over the life of an asset. Such judgments are gleaned from all of the available information, both past and present. But each investor, they argue, necessarily interprets the same pieces of information differently, and thereby assign varying degrees of probability to each potential outcome. In this sense, information is not simply a commodity, but a means of forming an opinion or expectation about the future. And, therefore, it is the way that investors interpret such information that matters and which can often lead to irrational prices and opportunities for profit. Ultimately, active managers believe that asset prices are an amalgamation of competing views and opinions about the future and that those endowed with superior insight and judgment can in fact beat the average market return.
A common argument against the efficient market hypothesis is that many investors have been able to consistently beat the market over time. If financial markets were truly efficient, they say, then it would be impossible for investors like Buffett to have amassed such staggering wealth. But in the early 1980s, Michael Jenson, an esteemed professor of corporate finance, argued that such performance could be chalked up to a simple coin tossing experiment. Imagine a very large population of coin flippers, he said, who agree to wager on the correct toss of a coin, each and every day. An incorrect wager would force that person out of the game, while a correct wager would allow them to proceed to the next coin toss. If you started with a population of 225 million people, then after 10 days, you would be left with about 220,000. And after 20 days, you would be down to about 215. The most successful investors, Jenson argued, are analogous to this crop of surviving coin flippers. They are the statistically necessary outcome of a simple probabilistic experiment. In other words, they are just plain old lucky. Jensen’s coin tossing analogy inspired a response from none other than the Oracle of Omaha himself.  In a now famous lecture, Buffett cheekily noted that 225 million coin flipping orang-utans would also produce the same result. But at the end of the 20 days, if you found that the majority of those orang-utans hailed from the same zoo, then you might want to find out what they were eating! Buffett proceeded to show that a disproportionate share of the most successful “coin flippers”, in the investing world, also hailed from the same “zoo”. Namely, an investment tradition inspired by the teachings of Benjamin Graham and David Dodd. These “Super Investors of Graham and Doddsville”, Buffett said, reflect a concentration of winners that could not be explained by a simple probabilistic game of chance or luck.
Buffett’s rationale is often touted in support of active management and the idea that financial markets are inefficient. Investors can in fact beat the market, they say, by applying the tried and tested investing principles of Graham and Dodd. But at this year’s annual meeting of Berkshire Hathaway shareholders, Buffett opened his usual remarks by acknowledging a certain attendee for their contribution to the wealth management industry. That person was none other than Jack Bogle (creator of the world’s first index fund and founder of the Vanguard Group). What is Buffett doing raising a toast to the world’s preeminent passive fund manager? Well, it gets even more confusing from there. He then told the near 40,000 Berkshire devotees that the vast majority of investors should avoid trying to beat the market and instead put their hard-earned capital in a broad index fund. He also noted in a 2014 letter to shareholders that, upon his death, the trustees of his estate have been instructed to invest in a S&P 500 index fund (for his wife’s benefit). Buffett said that the “long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers”. It is nothing short of ironic that thousands of aspiring investors travel to Omaha every year only for Buffett to turn around and say: invest in index funds! More importantly though, doesn’t Buffett’s endorsement of passive investing contradict his earlier response to the Jensen coin flipping experiment? What about the Super Investors of Graham and Doddsville? Moreover, if financial markets can in fact be beaten (and ergo are inefficient), then surely index investing makes no logical sense? How do we reconcile this apparent contradiction?
Our answer is that financial markets are neither efficient nor inefficient; they are a combination of both. In other words, both passive and active management are viable and legitimate investment strategies. This apparent contradiction stems from a false dichotomy at the heart of financial markets: that passive and active management are mutually exclusive. The problem with this idea is that each approach necessarily relies on the prevalence of the other in order for it to succeed. Passive investing inherently relies on the rational effort of others to ensure that asset prices remain efficient, and thereby generate the average market return. On the other hand, active investing relies on irrational and uninformed investors to create inefficient markets and, therefore, opportunities to beat the market return. To put it more simply, because passive investors are motivated by price rather than value, they are dependent on active investors to ensure that prices do not detract from value. Similarly, because active investors are motivated by value rather than price, they are dependent on passive investors to create disparities between price and value. Hence, active management is impossible without passive, and passive is impossible without active.
Accordingly, we view the tension between active and passive management, not as a contest between two conflicting ideologies, but as a marriage between two complementary forces of capital allocation. Between momentum or price-driven investing, on the one hand, and value or fundamental-driven investing, on the other. This relationship is also borne out of by the academic literature, which shows that value and momentum based returns are negatively correlated both within and across asset classes. Furthermore, the relationship makes intuitive sense if we consider the fact that expected returns on an asset class are likely to decline as a market becomes populated with more passive investors, while expected returns are likely to increase with more active investors. In other words, as more price-motivated (momentum) investors enter a financial market, they are inherently compelled to purchase more and more of the same securities and thereby reduce the prospect of being adequately compensated for the risk borne. On the other hand, as more fundamental-driven (value) investors populate a market, the prospect of returns is likely to increase for the level of risk borne, as more and more investors insist on buying assets at a discount to intrinsic value.
*Dear reader, the rest of this section is highly technical (and rather dry). We encourage the non-professional reader to skip through to Part II: Are Index Funds Creating a Bubble? See HERE.
We believe the complementary forces of active and passive may be modelled in a manner akin to that of economic supply and demand (See Figure 1). The relationship between expected return on assets (E) and the total number (Q) of passive investors in a financial market, may be modelled by a downward sloping curve (Momentum), while the relationship between expected returns (E) and the number (Q) of active investors may be modelled by an upward sloping curve (Value). The point at which these curves intersect denotes a financial equilibrium, whereby the total number of active and passive investors (QE) is such that asset prices equate to underlying economic value and expect to yield the average return on assets (ER). We posit that the slope of the Momentum curve is determined by the size of an asset class, whilst the slope of the Value curve is a function of profitability. Given that smaller businesses tend to generate higher returns than larger companies, expected returns will be lower in a financial market comprised by larger assets (as represented by a more rightward point along the Momentum curve), whilst a smaller asset class would expect larger returns on capital (as represented by a more leftward point along the Momentum curve). Similarly, a more profitable asset class would expect higher returns on capital (as denoted by a more rightward point along the Value curve), while a less profitable asset class would expect lower returns (as represented by a more leftward point along the Value curve).
Asset size and profitability determine the expected return on assets by way of movements along the value and momentum curves. But an entirely new point of equilibrium, from a shift of the value or momentum curves, would only be possible through a change in the overarching investment patterns of the asset class. For example, an increase in the number of new business entrants would result in a rightward shift of the value curve, as prospective returns are competed away by the presence of additional profit seeking entrepreneurs. Similarly, an exodus of businesses would cause a leftward shift of the value curve, as fewer market participants and less competitive pressures would expect to yield higher returns for investors. On the other hand, a change in the aggregate time preferences of investors would cause a shift of the momentum curve. For instance, an effort by central bankers to decrease the supply of money or raise interest rates would cause a rightward shift of the momentum curve, as investor time preferences are pushed back to the future. In this sense, higher interest rates would actually stimulate, rather than depress, risk taking behaviour, because a smaller portion of capital is needed to satisfy investor need for savings. The purported impact of asset size, profitability and investment patterns on the expected return of assets is also borne out by the academic literature. Overall, we believe that this mental model accurately reflects the true economic character and trade-off between active and passive management, as well as the underlying causes of the return on capital.
“I think it’s essential to remember that just about everything is cyclical…. …Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero” – Howard Marks.
Our characterisation of active and passive, as an equilibrium or balance between momentum and value investing, is reminiscent of an idea expounded by Benjamin Graham – the father of value investing. Graham observed that in the short term, financial markets are voting machines, but in the long run, they are weighing machines.  In other words, asset prices often diverge from economic value because of the irrational behaviour of investors. Human nature and psychology cause investors to overreact and underreact in their capital allocation decisions, which then leads to fluctuations in asset prices and inefficient market outcomes. Over the long run, however, asset prices tend to revert back toward underlying economic value, as relevant information is dispersed, digested and acted upon by rational individuals. In this sense, financial markets are inefficient and irrational over the short term, but they are efficient and rational over the long term (as opposed to being one or the other). Therefore, just like economics, everything in investing moves in cycles. Financial markets innately swing from boom to bust, peak to trough, and euphoria to depression. These cycles are akin to the swinging movement of a pendulum, whereby the midpoint represents a moment when asset prices reflect underlying economic value, and expect to yield the average return on assets.
The best hallmark of an investment cycle is the propensity for risk. Risk, in this sense, is the likelihood that an investor will suffer a permanent loss or impairment of their capital. Risk (and safety), therefore, are not a function of asset quality, but of the price paid. The prevailing appetite for risk is what drives the level of irrational market behaviour and the extent of inefficient market outcomes over the near term. For example, an increase in risk appetite would invoke a movement below the point of equilibrium; while an increase in risk aversion would reflect a movement above the long run expected return. In the former case, higher risk appetites would encourage investors to buy up assets at higher prices, as denoted by an increase in the number of momentum investors. It could also denote a decline in the number of value investors, caused by the impact of prejudice or bias on their decision making. On the other hand, increased risk aversion would encourage investors to demand a greater divergence between price and value (a margin of safety), as reflected by a movement up the value curve. It could also denote a movement up the momentum curve, as a result of an unwillingness of investors to buy any assets at all, due to fear or panic about the future.
As noted by Howard Marks, “cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal”. Therefore, over the long term, financial markets will inherently revert back toward equilibrium. The duration and extent of the cycle (or inefficiency) will depend on barriers to access and interpretation of information by investors. But so long as investors remain irrational, conformist, insecure, and inherently flawed, so too will cycles and inefficiencies continue to dominate the investment landscape. This understanding of the capital allocation process reveals a clear culprit in the false debate over active and passive management: the ignorance of time. Without time, it is impossible to understand the dynamic nature of financial markets. The process by which momentum and value investors interactively discover prices that approximate value and expect to yield the average return on assets. Such long run efficiency is akin to the economic balance of supply and demand. In the latter case, producers engage in a competitive process to yield the most efficient allocation of resources in an economy. In the former, value investors engage in a competitive research and analysis process to allocate capital efficiently through time. Both bottom-up processes innately draw on the tacit knowledge of individual circumstance to create spontaneous economic and financial orders.
 For a small taste of such commentary, see: Robin Bowerman, “Settle the Passive-versus-Active debate with Both”, AFR, September 21, 2015. http://www.afr.com/personal-finance/settle-the-passiveversusactive-debate-with-both-20150921-gjr5uy
 Stephen d. Simpson, “A Brief History of Exchange-Traded Funds”, Investopedia, http://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp
 For an excellent and more complete primer on index funds and practical advice for the average retailer investor, see: John C. Bogle, The Little Book of Common Sense Investing: the Only Way To Guarantee Your Fair Share of Market Returns, Wiley, 2007.
 A firm’s total market capitalisation is equal to the total number of publically issued shares multiplied by their current market price.
 Managed investment schemes are also known as ‘managed funds’, ‘pooled investments’ or ‘collective investments’. For more information see: http://asic.gov.au/for-finance-professionals/managed-investment-scheme-operators/starting-a-managed-investments-scheme/what-is-a-managed-investment-scheme/
 If an investor goes to sell their ETF unit on the market, but no other investors are willing to buy it from them, then the ETF provider is required to be the market maker or counterparty to the transaction, at a price relative to the fund’s net asset value (NAV). Such market makers are also authorised to redeem or create units in the ETF. Creation or redemption of units is not a common occurrence for the most actively traded and popular ETFs. Nonetheless, it is still an important consideration for all investors, especially for those investing in thinly traded and smaller ETFs. See the ASX website for more information about buying, holding and selling ETFs, including the role of market makers and other counterparties: http://www.asx.com.au/education/etfs-etcs-courses.htm
 The shares of a closed end fund also trade on an exchange, like ETFs, but the fund manager is under no obligations to redeem or create shares at a price equal to NAV. Investor contributions or withdrawals may only occur through other willing market participants. As a result, closed end fund shares often trade at premiums and discounts to NAV. For a more complete breakdown of the differences between ETFs, closed end funds and traditional index funds see: https://www.fidelity.com/learning-center/investment-products/closed-end-funds/cefs-mutual-funds-etfs
 Jack Bogle, “The Lessons We Must Take from ETFs”, December 12, 2016. https://www.ft.com/content/f406d50c-bbcf-11e6-8b45-b8b81dd5d080
 A full breakdown of these differences, as well as the relative merits and drawbacks of each structure, is beyond the scope of this essay. However, interested readers should note that there is still much debate around which vehicle is best suited to a particular investor. And we encourage readers to consult the website of any major index fund provider to learn more about the practicalities of each investment structure.
 Burton G. Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Norton, 2016.
 See supra note 10.
 According to Bloomberg, a little more than a third of all assets in the U.S. are in passively managed funds, up from about a fifth a decade ago. In the first half of 2017, flows out of active into passive funds reached $500 billion: https://www.bloomberg.com/quicktake/active-vs-passive-investing
 Patrick Commins, “Ignore the Haters, ETFs are Awesome,” AFR, September 8, 2017.
 Thomas Heath, “Warren Buffett’s $100 billion problem: Finding Something big to buy”, AFR, September 11, 2017. http://www.afr.com/business/warren-buffetts-us100-billion-problem-finding-something-big-to-buy-20170911-gyf11u
Readers should note that this sum denotes effective cash reserves of around 100 billion USD, with the majority of such funds currently invested in short term Treasury securities. See Berkshire Hathaway quarterly report for more details: http://www.berkshirehathaway.com/qtrly/2ndqtr17.pdf
 For instance, the infamous ‘2 and 20’ compensation structure for hedge fund managers, which awarded the asset manager a 2% fee on all assets under, regardless of any performance. Admittedly, this generous remuneration scheme has become much less common since the GFC.
 Roger Montgomery, “Only dummies invest in index funds, a guarantee of average”, the Australian, October 22, 2016:
 Christopher Joye, “Passive Investing is Lobotomised Investing”, AFR, May 5, 2017, http://www.afr.com/personal-finance/shares/index-funds/passive-invested-is-lobotomised-20170504-gvyto5
 Jonathan Shapiro, “Platinum cautions against passive investing bandwagon,” AFR, May 3, 2017, see: http://www.afr.com/business/banking-and-finance/financial-services/platinum-cautions-against-passive-investing-bandwagon-20170502-gvxfdn
 Warren Buffett, “The Super Investors of Graham & Doddsville”, Columbia Business, May 17, 1984.
 This tradition of value investing began with the publication of Security Analysis by Benjamin Graham and David Dodd in 1934.
 Berkshire Hathaway 2014 Letter to Shareholders: http://www.berkshirehathaway.com/letters/2014ltr.pdf
 Asness, Clifford S. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53; Fama-Miller Working Paper. SSRN: https://ssrn.com/abstract=2174501 or http://dx.doi.org/10.2139/ssrn.2174501
 Risk, in this sense, is the likelihood that an investor will suffer a permanent loss or impairment of their capital. Risk is not a function of volatile asset prices – as it is commonly defined – but the fact that more things can happen than will happen in the world of investing. We revisit this notion of risk in further detail in Part II.I
 Similarly, a decline in the number of momentum investors is likely to cause asset prices to decrease and expected returns to increase, while a decline in the number of value investors is likely to cause asset prices to rise and expected returns to fall.
 Note that this model may explain why recent interventions by developed nation central banks to increase the money supply and depress interest rates have actually failed to generate meaningful capital investment activities – as opposed to rising asset prices.
 This view is more aligned with the Austrian theory of the business cycle, than mainstream economics: Hayek, F.A (1990), Denationalisation of Money – The Argument Refined: An Analysis of the Theory and Practice of Concurrent Currencies, Third Edition, The Institute of Economic Affairs.
 Fama, Eugene F. and French, Kenneth R., A Five-Factor Asset Pricing Model (September 2014). Fama-Miller Working Paper. Available at SSRN: https://ssrn.com/abstract=2287202 or http://dx.doi.org/10.2139/ssrn.2287202
 Howard Marks, The Most Important Thing Illuminated, Columbia Business School, 2013, pg. 81
 Benjamin Graham, The Intelligent Investor: The Definitive Book on Value Investing, Harper Business, 2006.
 See supra note 29, Chapter 9.
 Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. 1991. New York: Harper Collins Publishers.
 See supra note 29, pg. 82
 F.A. Hayek, “The Meaning of Competition”, excerpt from Individualism and Economic Order, 1948.
 F.A. Hayek, “The Use of Knowledge in Society”, The American Economic Review, Volume 35, Issue 4 (Sep. 1945), 519-530: http://home.uchicago.edu/~vlima/courses/econ200/spring01/hayek.pdf