I am reminded of the old Jim Henson series, Fraggle Rock. In this show there were characters named Doozers. Doozers built wonderful structures only to have them eaten by fraggles. The interesting part was that the Doozers knew the eventual outcome prior, were content with it, and went about building. This creative destructive feedback loop imitates our great capitalistic society. And at the cornerstone of this society is our wonderfully efficient free market system. This market sees to it that strong participants succeed and weak ones fail and with the barriers to entry not absolute, new participants are free to enter. Some of these new entries will indeed become strong and prosper.
Sharpe's piece highlights this creative destructive force, and I liken the Doozers to active managers. If Sharpe's theory holds, then active managers know their eventual demise (or are just blissfully ignorant), are content with it, and go about investing while their passive brethren achieve superior returns "for any time period" (pg. 1 of Sharpe's paper). There is a very subjective classification underlying this whole assumption, a proper definition of passive. While passive undoubtedly infers less frequent, does less frequent infer passive? No.
A recent market example will properly contextualize this. The energy sector's increased market weighting over the last few years coupled with the financial sector's demise. The active investors in the commodity arena started the cycle with crude oil contracts (reference the explosion of open interest). The increased price led to massive profits for the large integrated oils and even sparked debate over a windfall profits tax. These increased corporate profits sent share prices and market capitalization of these companies higher sending other active investors in to exploit the apparent inefficiency of current prices. Then the passive investor gets involved due to the fact that they must keep relative market weightings. On their re balancing (whatever frequency), these passive investors are forced to buy these energy companies and sell financial holdings. Buying performance at the expense of selling under performance does not bode well for sustainable returns, in essence it's the inverse of buying low and selling high.
These passive investors have participated in a less frequent manner, but their magnitude is what's interesting. Does less frequency and greater magnitude as a function of the activity of the active investors really then infer passive? No. It seems the only ones who truly prosper from this example are the brokers or those active investors who initiated and then sold to the passive investors forced in by their actions.
Active investing begets active investing if not by frequency then by magnitude, albeit passively.
If this argument happened to spur some thoughts on how is it mathematically possible to keep the market weighting at any point in time with a portfolio, don't fret because it is not possible with a finite amount of capital. To remedy this, Sharpe aggregates all investors he defines as passive. This flawed logic is supported by more flawed logic. Footnote 4 states,
"We assume here that passive managers purchase their securities before the beginning of the period in question and do not sell them until after the period ends. When passive managers do buy or sell, they may have to trade with active managers, because of the active managers' willingness to desired liquidity (at a price)."
When one buys or sells a security it usually happens at a specific date and time, thereby becoming their reference point for that security. These footnoted passive managers do not have a transaction reference point for their investments. Seems two wrongs make a right to Mr. Sharpe.
One last glaring inconsistency with Sharpe's analysis is his definition of passive. If a "passive" fund receives inflows and rebalances monthly are they then classified as active because the weighting in their portfolio will be diluted by those inflows during that period?
"An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times."
If the inflows have effected a dilution of the passive manager from market weights for some of the time, then they must be defined as active according to Sharpe. But I guess if you do not consider the transaction a reference point for your investments, it really doesn't matter. It seems the only way to achieve passive status is to inherit a market weight portfolio and to will it to posterity upon your passing. However, the government rectifies this by forcing the recipient to mark the portfolio's cost basis at the day of inception for tax purposes, therefore creating the reference point Sharpe's argument assumes does not exist. Perhaps there is no such thing as "passive" investing.....only degrees of active, which gets foolishly ignored in the aggregate.
