During the 2023 December holidays, I had the privilege of taking some time out to read a few lengthy nonfiction books and I am so pleased I did, as I stumbled upon “Trillions” by Robin Wigglesworth and what a treasure trove of information it unlocked.

For those who are too busy to take the time to read it (and it is not short), I thought I would share some of the more interesting takeaways.

Let’s start with the value that active managers add, well to put it bluntly, the book argues that passive convincingly outperforms active management over the long term, but they do argue (rather tongue in cheek) that at least active management is useful, as it convinces investors to invest in stocks, which have over time shown superior returns to bonds and cash in the bank.

What I also learned is that active managers historically charged up-front fees, some as high as 8%, so it’s probably not all that surprising that passive investments have outperformed. For the benefit of all investors, the rise of passive investing has led to a fee reduction across the industry, so those early easy wins are not as prevalent today. It is also one of the reasons that active management in bond investing has often shown impressive returns versus a passive, as starting fees of bond managers are a lot lower than those of equity managers.

But passive investing is not only about the fee argument, it also tames the demon of chance. As Markowitz argued, (a big proponent of the efficient market thesis) a broad-based passive portfolio of the entire stock market is the only “free lunch” available to investors. Many active managers do not agree with this view, but he strongly argued that the past could not be used to predict the future in any meaningful way – so essentially stock picking is a loser’s game.

Paul Samuelson in 1974 (the first American to win a prize in Economics), argued that there was nothing in the Efficient Market Hypothesis that precluded some incredibly brilliant fund managers from consistently beating the market, such skill was scarce and those who did possess it were unlikely to rent their talents out cheaply to all and sundry. Most managers overtraded and their costs of trading failed to provide alpha. (On that score, we have several incredibly talented managers in SA & costs of trading have fallen substantially since 1974).

And if you really wanted to support an active manager, the evidence is against you, with the S&P Dow Jones publishing their “Persistence Scorecard”, showing that less than 3% of top-performing equity funds remain in the top after 5 years. In fact, it shows that alpha means reverting when it comes to relative return funds.

Bogle, the founder of Vanguard, took this research to heart, with the mantra, if you cannot beat them, why don’t you join them, by launching passive/ tracker funds, with low costs that would end up beating the majority of active managers. Several of his friends noted that Bogle was a dreadful cheapskate, so the idea of a “cost matters hypothesis” for running low-cost trackers really appealed to him. Essentially the idea was born, alpha is unpredictable and most active managers fail, so why not compete on price, which is a given. (Vanguard is one the largest fund managers in the world today with an AUM of over USD 7.6 trillion). What is more, over the past decade 80c of every dollar that has gone into the US investment industry has ended up in Vanguard, State Street and Blackrock!

Research around the world continued apace and in the late 1960s and early 1970s Gene Fama argued that the reason the market was so efficient and therefore hard to beat, was because thousands of investors were trying to outsmart each other and by doing so, prices readily reflected all known information. Having an edge was hard to find and investors would be better sitting on their hands and buying the whole market.

However, as with all good academic research, the efficient market theory was upended in the 1980s and 1990s with some academics arguing that perhaps markets were not entirely efficient and that active management could outperform. Already in the 1970s, critics of the efficient market theory had argued that if markets truly were efficient, low beta stocks actually produced better long-term returns than higher beta stocks, which was not possible under efficient markets (where higher risk should lead to higher returns).

This did not lead to the demise of passive investing (the lower cost was still a massive benefit), but did lead to factor-investing, in which the research showed that value or small caps, or quality factors could lead to outperformance of the overall market.

Efficient markets still argue that value investing and small cap investing did not counter their efficient market views, as value stocks were often in poor industries, and had weak balance sheets, so one received upside performance for the risk you were taking. Small cap companies were more likely to bankrupt, so there too, one took on additional risk to achieve higher returns.

Behavioural economists took this argument one stage further saying that factor investing was a sign of our irrational human biases, given that we tend to overpay for shiny, exiting, high-growth stocks and that leads value shares (that are often boring), being underappreciated and leading to lower entry points for investing. (One only must-read PSG’s investment research in South Africa to agree with this view). Momentum investing helps to alleviate the human bias of investors tending to sell their winners too early and hang on to loss-making investments too long.

The problem, as many have come to appreciate (especially in US markets), is factor investing can have years of underperformance, as seen by value hugely underperforming growth in the tech bubble and again over the last few years (as can be witnessed by the magnificent 7).

The graph below illustrates that value and growth are mean reverting, with no one style consistently outperforming (it is only up to 2020, but it’s a good graphic). It also illustrates why factor investing can be tricky as one style can outperform for years on end and it remains the holy grail of investing to establish when one style is coming back in favour (spoiler alert, over the long run, when one style stretches too far, it tends to lead to many years of outperformance of the other & why one needs to parent with a financial advisor to advise on this & balance up different portfolio styles in one’s portfolio).