Why Swensen, Buffett Preach Passive—But Bank on Active

Some of the biggest proponents of passive investing don’t practice what they preach on the active versus passive debate, according to Morningstar’s Vice President of Research John Rekenthaler.

In his latest column, Rekenthaler argued that while financial experts including Richard Thaler, Eugene Fama, Warren Buffett, and David Swensen advise other investors to stick to index funds, they themselves are active managers.

“The very people who have been most associated with the boom in indexing run actively managed portfolios. What gives?”Thaler is a principal at active management firm Fuller & Thaler Asset Management, Buffet picks stocks for Berkshire Hathaway’s portfolio, and Swensen actively manages Yale’s endowment fund.

Even Fama, who Rekenthaler acknowledges is “not fully an active manager,” is “more of one than you would think, given that he’s the person dubbed by Wikipedia as the ‘father of the efficient-markets hypothesis.’”

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Other indexing advocates who the columnist called out as active managers included Harvard professor Andre Perold, Yale’s Roger Ibbotson, Nobel laureate Myron Scholes, University of Illinois professor Josef Lakonishok, and MIT’s Andrew Lo.

“Academic literature, MBA classes, and the media encourage investors to index,” Rekenthaler said. “Meanwhile, many of the most informed, influential researchers, the very people who have been most associated with the boom in indexing, run actively managed portfolios. What gives?”

The Morningstar researcher attributed this difference between action and advice to the “twin temptations of ego and lucre.”

“Although none of these experts will admit it, they each believe that they are smarter than the rest of the market’s schmoes,” Rekenthaler wrote. “Their confidence is understandable. They are very bright. They have had tremendous professional success. And, for many of them, their belief in their own abilities has been vindicated by the investment results.”

The other reason why these experts don’t invest as they advise is because even “avid advocates of market efficiency, and thus of indexing, lack complete faith,” Rekenthaler said.

“Yes, the financial markets are typically ruthlessly efficient at absorbing investors’ aggregate knowledge and incorporating those insights into stock prices, but they have all seen strange things occur… often enough to give pause to any notions of full market efficiency,” he wrote.

For example, Rekenthaler pointed to the continuing success of the momentum factor, which Fama has called the “biggest embarrassment for efficient markets.”

“It makes sense for financial experts to recommend indexing to outsiders, and it makes sense—psychologically, financially, and intellectually—for them to behave otherwise,” he concluded.

Asset managers who grew up poor deliver higher returns than those raised in wealthy families, researchers have found.

“An individual’s social status at birth may serve as an important signal of quality in industries with high barriers to entry.”Managers with low-income backgrounds faced higher entry barriers into asset management, and therefore had to perform better to gain access and opportunities, argued Oleg Chuprinin from the University of New South Wales and Denis Sosyura of the University of Michigan.

“Because individuals from less privileged backgrounds have much higher barriers to entry into prestigious positions, only the most skilled types can exceed these high thresholds and build a career in a management profession,” they wrote.

For the study, Chuprinin and Sosyura compared the performance records of mutual fund managers with US Census records on the wealth and income of their parents. They found that most managers came from families that were richer and better educated than the general population, with the average income of managers’ fathers at the 90th percentile of income distribution in the general US male population.

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Managers’ fathers obtained an average of 12 years of education, and the managers from wealthier backgrounds were themselves more likely to attend private or more exclusive universities.

However, these managers also delivered consistently worse returns those from more disadvantaged backgrounds, with managers in the top quintile of parental income distribution underperforming those in the bottom quintile by 1.54% per year.

“Individuals from wealthier families have better connections and access to resources, which should aid their portfolio management task,” the authors wrote. “And yet, these same privileges make it possible to make career advancements without showing strong performance.”

For example, Chuprinin and Sosyura found managers with negative or neutral past performance were increasingly likely to be promoted the richer their parents were. A manager from the 25th percentile of parental income had to outperform a manager from the 75th percentile by 0.74% per year to stand an equal chance of promotion.

“Managers with a low-endowed status must deliver higher returns to stand a comparable chance of promotion with their high-status peers,” the researchers concluded. “An individual’s social status at birth may serve as an important signal of quality in industries with high barriers to entry.”