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Curiosity, behavioural bias and a totally passive question.

I’ve always found that there’s a problem with being curious.  Sometimes you realise that what you believed to be previously correct is in actual fact absolutely wrong!

On or off over the past 6 months or so I’ve been considering the benefits of active fund management vs a totally passive approach. Within my business we still use a combination of both active and passive funds (using outsourced portfolios) however the problem is that the more I think about it, read about it and seriously think about where I add value to my clients it’s raised a few questions…

Whilst I’ve never considered myself a ‘fund picker’ however I’ve been outsourcing the responsibility of doing this to the individuals on an investment committee….whats to say this committee would do better or worse than a completely random selection or an aggregate of all the funds in a particular market sector?

Also, with the majority of fund managers in a particular sector underperforming the index (at a significantly higher cost than purchasing a passive fund) have we, for many many years, bought into a fallacy?

We’ve all been told that for many years we need fund managers.  We need “Alpha”.  We need a real person making day to day decisions to help our money grow or reduce the level of risk.

However there’s a few problems with us ‘humans’ when it comes to managing money.  We’re expensive.  We tend to be emotional when we make decisions (including investment ones) and most of the individuals actively managing money don’t seem to do any better than a computer!  Even fewer, if any at all, managed to outperform the ‘computer’ with any degree of long term consistency.

So, if the numbers tell us that the majority of active fund managers are worse (and on some occasions far worse) than a computer…shouldn’t we look at asset allocating and just automating the various assets within a portfolio using a passive vehicle?

However one issue (raised by Richard Allum on Twitter yesterday) with the passive model is that they are dependent on the market.

The market for most investment assets in the UK is, on the whole, an active market.  The majority of the decisions made aren’t made by computers. They are made by humans.

Pension Trustees, Institutional investors and individuals are all actively buying and selling assets. Whilst their decisions may be driven by a combination of both emotion and logic (with the decisions, in hindsight, being a mixed bag of good, bad and indifferent) it does generate a market due to having a wide range of individuals having different opinions about the value of a wide range of assets.  It’s one of the reasons we have markets in everything from cars to paper, oil to diamonds and shares to bonds.

If the market was entirely passive is there a risk there wouldn’t be a market at all?  Computers would all make rational decisions so with emotion taken out of the equation how would the market could work?

Alternatively would an entirely passive market  just mean that over time the market would just become incredibly efficient.  Instead of emotional decisions asset valuations would be entirely based on facts and wouldn’t be subject to the behavioural biases humans suffer from.

In my opinion it will be a long time (if ever) until we move lock, stock and barrel to passive markets.  Whilst there are economists who disagree, humans make decisions emotionally ever before they make a decision rationally…this is a good sign for the continue life of active markets!

However the issues I’m trying to get my head around (and really need your help on) are these:-

*  Could a totally passive investment market in any asset class ever exist?  If it existed could it work?  Would it be easier in one asset class than another?

*  Are there any other advantages or disadvantages to a totally passive market I haven’t considered?

*  Is the smart thing to do in a market with both active and passive funds to ‘go passive’ and let the active markets continue as it’s always done?

As ever I look forward to hearing your thoughts…

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