Based on My True Stories, I’ll Let You Decide
While surfing Twitter recently, I noticed another long debate about the difference between passive and active investment management.
When the debate turned to the meaning and use of the words “active” and “passive, I chimed in by sharing a brief tale of time I spent at a firm that had two different investment management divisions on two different floors.
These two divisions had very different internal cultures as well as very different approaches to investing – approaches that today are called passive and active.
I’m not a great Tweeter and a few people asked me tell this story in a little more detail, so here goes.
Before I dive in, however, let’s briefly review the definitions of “active” and “passive.”
According to the dictionary, “active” means “vital” and “dynamic” and has synonyms such as “hard-working”, “diligent” and “effective.”
By contrast, the word “passive” means “inert” and has synonyms such as “docile,” “acquiescent” and “compliant.” Its literal antonym is the word “active.”
Humans are hard-wired to be attracted to people and things that are vital. It’s a Darwinian survival instinct. We are also generally competitive and socialized to place a premium on people and processes that are diligent and effective (active).
Translating this to investing, pause a moment. How do you feel when you hear that certain types of investors are called Passivists? Chances are, not so great.
One of my favorite quotes about this comes from a talk I heard Charles Ellis give at an investor roundtable. For those of you who don’t know Charlie, he has many more stories and investment experiences than most anyone I know. He has interviewed hundreds, if not thousands, of professional investors in his role as the founder of Greenwich Associates, a leading institutional investment consultant. In addition, he evaluated many investment managers as the chair of Yale’s investment committee for nine years alongside David Swensen.
Ellis was asked: “What is the biggest risk investors face when investing in index funds?”
His answer? “Being called passive.”
Yes, regardless of your investment background, deep down you are likely to be more attracted to an investment or firm that sounds dynamic and vibrant versus one that sounds docile and inert.
Word and labels matter and, with this all in mind, here’s my story.
In the late 1980s, I worked in an equity investment division that was, by any standard, extremely vital and dynamic. The culture on the floor was fast paced, with investment market review and strategy meetings that started at 6am. Days were generally 10-12 hours long and it wasn’t uncommon to come in on weekends. We worked hard to analyze every aspect of what we did and diligently strove to optimize our performance to meet our investment mandate. This included proprietary quantitative and qualitative research conducted by a sizable group of CFAs and math PhDs about how the market was changing and how to most efficiently trade for the maximum benefit of our clients. Returns were evaluated daily versus our benchmark and our performance was reported monthly to clients, net of all fees and expenses.
A few floors below was another equity management group. I was just starting out, so I was often asked to carry memos back and forth (yes, this was a long time ago – emails were not common) and sometimes we had joint meetings on their floor (their conference room was much nicer than ours). On this other floor, the pace felt much slower and the energy was much lower. Even though we enjoyed the faster pace on our floor, sometimes we were a little jealous. It was well known that work on this floor generally started at 9am, lunches tended to run long and often took place in the executive dining room on the top floor of the building. When I visited, it wasn’t uncommon to see feet up on desks and very little apparent activity. Their investment operations and process was also quite different. Unlike us, they didn’t have a trading floor or a separate research group. In fact, they didn’t do much independent research themselves and didn’t really question the research provided to them by institutional equity sales professionals. They held what people at the time called “buy and hold ABC portfolios” (one stock per letter of the alphabet – Anheuser-Busch, Boeing, Caterpillar, Dow, etc. – if it was part of the DJIA, it was considered just fine). The floor was generally empty by 5:30pm and I never heard of anyone there coming in on a weekend. This group sent reports to clients once a quarter, but they didn’t include performance figures and, if you asked them, they couldn’t readily tell you what their gross of fees and expenses performance was versus their benchmark (they didn’t have systems to track net of fees and expenses performance).
Based on this, which floor or division would you call active versus passive?
Without my lead-in, my strong guess is that you would instinctively call the 10-12 hours a day, fast paced floor the active division and the more staid, 9 to 5 floor the passive investors.
If so, you would be wrong.
The more active floor I sat on managed large institutional S&P500 index funds. They are now one of the largest index firms in the world and, from what I hear from friends working there, the pace is as active and dynamic as ever.
The other division was sold to another large firm, but it still exists and manages money for UHNW individuals and foundations. Based on meetings that I still have at the firm from time to time, not much has changed (some of the people are older but still in similar hear-a-pin-drop offices). Their ABCs now include Alphabet, but changes are basically nonexistent and they still don’t report performance on a regular basis. Also, when they do, it’s still gross, not net of fees and expenses (one of their most recent presentations is on my desk now). Bottom-line, it’s hard to call their approach anything but passive.
In saying all this, I’m not trying to win a debate about which style of investing is better. Boring and staid can perform well and, during different time periods, the arguably more passive buy and hold ABC portfolio that I described almost certainly outperformed the S&P 500 and vice versa.
Instead, I’m hoping that the next time you hear someone label a certain type of fund or ETF passive or active, you will ponder how it is being presented, the emotions the labels invoke, and how they can drive investor behavior. Are these labels sometimes wholly divorced from how actively or passively portfolio managers work and the processes they employ?
I think so.
In another past life I helped develop, market and sell what are called actively managed equity funds. I was good at it, and even won an award for selling more actively managed equity funds than anyone in the history of my division. I can tell you that even in the 1990s, we had many training sessions on investor behavior and knew well how to use words such as active and passive to influence investors and sell products.
I’m sure many will comment on this post and offer alternative stories and experiences. I welcome this and only ask that more people think about these questions.
Back in the 80s, index investing existed, was already large and growing (we managed multiple hundred million dollar plus accounts for the likes of CalPERS, etc.), but I can’t remember hearing the terms passive or active.
Why is it, then, that today, professionals like the ones working on my old more active floor are now called passive and the more passive acting professionals on the other floor I mentioned are called active?
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