Active Passive Word Play

I think that most people in the investment business have at one point, or another wrestled with the question about whether the market is efficient and what you should do about it, regardless of your answer.

In simple terms, an efficient market quickly incorporates news and information into prices.

It’s easy to find examples of market inefficiency, like when companies added .com to their name in the late 1990s and got a big boost in prices.

It’s also hard to argue that the market is totally inefficient. A totally inefficient (or chaotic) market wouldn’t respond to news at all. A company could announce the cure for a major, widespread disease, and in a chaotic market, it would be a coin toss on whether the company stock price rose or fell.

Of course, that’s not the case, so the question is the degree of market efficiency that exists. As a parlor game, I asked investors I admired how efficient they thought the market was on a scale from 1-100.

Mostly, people said something between 60 and 90, and I thought those were fair answers since I’m in that camp at around 80.

Here’s the thing, though: even if you think the market is pretty efficient, as I do, the next question is what to do about it. This gets to the classic debate about active versus passive management.

An active manager picks stocks based on their fundamentals and valuation on a discretionary basis. A passive investor favors index funds, or something similar.

This was on my mind recently because I went to a conference put on by Dimensional Fund Advisors (DFA). They aren’t indexers, but they offer passive funds, meaning that they are systematic rule-followers, but don’t track indexes.

They make a compelling case that they can do better than indexes through a variety of techniques. For example, they employ what they call flexible trading systems that don’t force them to buy or sell based on an index rule change.

For example, when the S&P 500 added Tesla a few years ago, index funds all had to add Tesla at the same time, but DFA could buy before or after the index funds, and avoid the high price associated with everyone buying at the same time.

DFA offered mutual funds that were only available through advisors, including Acropolis. They recently launched some exchange-traded funds (ETFs), so anyone can buy them now, which is probably a good thing.

They’ve had a lot of success raising funds for their ETFs, partly because advisors (like us) prefer the tax-treatment and liquidity of ETFs and are selling the mutual funds to buy ETFs.

And this is the punchline to my article: DFA promoted the success of their ETFs by saying that they are now the largest active ETF provider. That’s funny because of the word active. For decades, they’ve railed against active managers, but because ETFs were all indexes until recently, non-index managers are considered active. Pretty funny, right?

Okay, maybe you didn’t laugh out loud, but it goes to show that our industry is full of odd word choices. It’s even funnier at this moment because the SEC, who is forcing DFA to call itself the largest active manager, put out some new rules requiring funds to have names that match the strategy.

That seems like a good idea, but the whole active/passive issue highlights how difficult the task might be. I can understand the problem of having a fund with Treasury in the name that’s full of junk bonds, but I don’t think that was commonplace.

In my mind, it’s further evidence that you can’t rely on the name of a fund to tell you much about it. Understanding the holdings and history will tell you what you need to know, not the name.