WSJ: “Why the Math Behind Passive Investing May Be Wrong”

Wesley R. Gray has an interesting piece at today’s WSJ: “Why the Math Behind Passive Investing May Be Wrong.” It’s zeroes in on the research of William Sharpe who was an early advocate of passive investing. Here’s a sample:

A recent essay by Druce Vertes at the CFA Institute, and more formal research by NYU Professor Lasse Pedersen, suggests that Mr. Sharpe’s conclusions might be incorrect. Dr. Pedersen offers a very powerful critique in a new white paper entitled, “Sharpening the Arithmetic of Active Management.” Dr. Pedersen argues Mr. Sharpe’s arithmetic relies on the faulty assumptions that the market never changes and passive investors never need to trade.

Objectively, these assumptions are false: The market is not static, as new firms are created through IPOs, new shares are issued or repurchased, and indexes are reconstituted all the time. Additionally, passive investors must sometimes rebalance their portfolios, for instance to raise cash or reinvest dividends. In short, passive managers must, and do, trade with active investors.

As evidence for the need of passive investors to trade, Dr. Pedersen cites the case of a theoretical passive investor in 1927, who never trades. After 10 years, this investor owns only 60% of the market. And this ongoing market turnover is persistent: The average turnover for all equities from 1926 through 2015 was a whopping 7.6% per year. Last year, the Vanguard 500 Index Fund reported turnover of 10%. Clearly, the assumption that passive investors never need to buy and sell is false. And this mechanical need to trade opens passive investors up to exploitation by active investors.

Posted by on November 7th, 2016 at 12:19 pm


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