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Swedroe: Active Investing A Waste Of Time
By Olivier Ludwig | March 03, 2011

Larry Swedroe, the research director at St. Louis-based Buckingham Asset Management, just had his book, “The Quest for Alpha: The Holy Grail of Investing,” published. It’s his 10^th and it’s not to be missed. It’s as concise and trenchant an indictment of active management as you’ll ever find.

When IndexUniverse.com Managing Editor Olivier Ludwig caught up with Swedroe recently, they talked about the active vs. passive debate and how Swedroe came to be such a passionate advocate of passive investing.

Ludwig: You talk about it in your book, but why the persistence of any sort of discussion in the active vs. passive debate, when the numbers seem so persuasive?

Swedroe: Because it’s simply not in Wall Street’s interest, because they wouldn’t be able to charge you big fees for active management anymore and because you can obviously run a passive fund much more cheaply. And also, you’d have to compete with Vanguard, DFA and others.

And the media needs you to tune in to hear what’s the best stock to buy and which funds are hot, etc. So they’re not going to tell you that passive investing is the winning strategy

So it’s really a question of whose interest these people have at heart. It’s very hard to convince somebody that they’re wrong when their economic interests are in the opposite direction. They just go through … I think psychologists call it “cognitive dissidence.”

It was Demosthenes who warned us that what each man wishes he also believes to be true. And Upton Sinclair, on the subject, said: “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand.”

Ludwig: How did you come to this insight that passive investing was the sensible way to go?

Swedroe: Well, it’s an interesting journey. I ran trading rooms for Citicorp, a foreign-exchange operation. I was responsible at Prudential Home Mortgage for hedging of our mortgage assets and interest rates. I also used to sell economic forecasts for Citicorp. I would go around the country talking about our economic forecasts, and sell them and technical analysis models to major corporations. I was a trained economist, so when I got a forecast right, of course I took credit for it.

And when I got it wrong, what did I do? Well, it wasn’t my bad analysis; I blamed some unexpected event that nobody could have forecasted. At the end of the day, if you do that, you’re a genius because you’re never wrong. You’re just unlucky on occasion. And overwhelmingly over time, I became convinced from reading all of the academic literature that this is a clear-cut case of the idea that “there’s no army strong enough to withstand an idea whose time has come.”

To me, the evidence is so overwhelming, that, while it’s not impossible to beat the market, it’s certain that so few people will succeed that it’s not worth trying. And there’s no way for you to identify these people ahead of time. The best evidence of that is looking at the performance, I think, of pension plans. Goldman Sachs has a consulting unit, and they did a study on pension plans. And they admitted that the overwhelming evidence is that pension plans are wasting money for active management.

That’s Goldman Sachs! And of course, Goldman Sachs sells advice to pension plans and sells their funds. Now, it doesn’t mean that there aren’t people who are always finding little inefficiencies and exploiting them.

The market, I would say, is always moving towards more efficiency. So you’ll find somebody who discovers an anomaly. So they can go and exploit it. But the very act of exploiting it makes the anomaly go away. That’s what killed Long-Term Capital Management, right?

Ludwig: You make that amply clear in your book. But, is it fair to say that at some point in the not-too-distant past that the efficient market hypothesis was on much shakier ground?

Swedroe: No, I don’t think so. All of the arguments against the efficient market hypothesis, in my opinion, are bogus. They confuse efficient markets with rational markets. To me, the real issue is this: To show that the markets are inefficient, you have to show that you can exploit these anomalies on a persistent basis. The fact that anomalies exist doesn’t mean much. The question is, which strategy should you adopt based on the assumption the markets are highly efficient or not? So you get anomalies, but they disappear very quickly.

And you can’t find managers ahead of time who are going to win. Even David Swensen of Yale advises individual investors that the winning strategy is to own index funds and be passive. The guy who ran Harvard’s endowment, Jack Meyer, said the same thing. Look at Peter Lynch—maybe the greatest mutual fund manager ever—what did he say? “You’re better off in an index fund.” What does Warren Buffett advise people? “You’re better off in an index fund.” One of my favorite quotes is the one from Ralph Wanger, who was the tremendously successful manager of the Acorn Fund. And you read his quote in the book; he basically says we’re all a bunch of charlatans.

Ludwig: Yes, that was powerful. You did a good job in your book of drawing far and wide from different people, essentially communicating the message that passive investing is superior to active. There also were some very good quotes you pulled from Jason Zweig of the Wall Street Journal.

Swedroe: Yeah, I’ve been collecting all those for 15 years. That’s why I put them in the book. So many people who are icons and were great successful active managers—in moments of truth or whatever—admitted that the best strategy is a passive one.

Ludwig: One of the things that I find striking about you, is you seem to be a rather prolific writer. Can you speak to that? Obviously you find the time for it, but where has the inspiration come from?

Swedroe: Yeah, well No. 1, I got lucky in my life, if you will. I grew up in the Bronx, lower-middle income family, and eventually had a successful career in investment banking. And I was Vice Chairman of Prudential Home Mortgage. I had a piece of equity in a deal, and I made enough money on it that I could retire. But I always tell people, you can’t retire from life. And I was going to go back and teach—at least I was going to try—because when I was growing up, I wanted to be a history teacher.

I loved history. I still read a lot today—lots of history and historical fiction. Those are my favorite two genres. But I knew there was no money in teaching, so I decided I had other aspirations as well. So, I went into economics, finance, and by the way, for what it’s worth—kind of ironic—I won the Wall Street Journal Award as the most likely to succeed in finance and investing, and now, here I am, sort of the antichrist of all of them.

Ludwig: That’s right, the pariah! So are these books part of your job at Buckingham?

Swedroe: Yes, and here’s how it started. I’ll give you the history. When I came to Buckingham, we worked with DFA because we believed their products were the best, and we had no literature at all to show prospects about what modern portfolio theory, efficient market or diversification was all about. So, I said what we need is to put together a brochure to show people. So I set out to put one together, and I wrote a 40-page brochure! And then I said, “You know what? We really need a book. There’s a power to the printed word that somehow conveys much more.”

The only good book I thought that was out there at that time—and now of course, there’s lots of good books—was Burton Malkiel’s “A Random Walk Down Wall Street.” But it was way too fat—though he did write a short version of it. So I said, “All right, let me take a crack at it,” and that’s how I wrote the first book, “The Only Guide You’ll Ever Need to a Winning Investment.” It took me two years and lots of work. And then, as my job as director of research at the firm, what I do is I read all of the academic literature. And I look in chat rooms, so I know if other people have questions.

Ludwig: So what brought this latest book about?

Swedroe: I was looking for a way to update my book, "The Only Guide to Winning Investment Strategy." People don’t want a 300-page book; they’re intimidated by it. The first thing I did was develop a speech on the subject of searching for the holy grail of investing alpha. So then I put the talk together, and I said, “All right, I’ve got all this material. It’s a good framework for the book. And I basically took that speech and wrote a book around that talk. It’s a much shorter version of my other books. It doesn’t go into everything like my other books do—the three-factor models and all that stuff.

Ludwig: How do you feel having written the latest book?

Swedroe: I think it conveys the message in a very short 150 pages, probably a three-hour read for most people. And the people I’ve asked to read it say: “Wow, Larry, this is really an ‘a-ha!’ moment.” So I’m really pleased with the book because the key is, it doesn’t matter how good a book you write if nobody reads it, or a few people read it. I wanted to write a much more accessible book.

Ludwig: Do you think that progress is being made in getting the message out about passive investing?

Swedroe: Oh, without question. Fifteen years ago, maybe it was a few percent of individual money that was passive. Now I think the estimates are maybe 15 percent. And maybe there were 25 percent of institutions that were passive, and that number is probably closer to 40 percent. So clearly there’s a trend.

It’s powerful. I think it’s unstoppable. I don’t think we’ll ever see the market at 100 percent, and that’s great. We need the active managers to allow us to be free riders, right? They spend all the money making the market more efficient, and we benefit from their getting the prices to be the best estimate of the right price.

Ludwig: So you’re an optimist that the forces of good will triumph over evil over time?

Swedroe: I have no doubt that that’s happening. We see every day that that’s happening. And I feel good that I have contributed in my own small little way. My hero in this is Jack Bogle. Here’s a great man who fights the good fight—a humble human being. And he’s only doing it for one reason: to help other people.