Siegel vs. Bogle Properly Understood

Over at one of the best economics blogs in the blogosphere, the estimable Prof. Greg Mankiw tackles the interesting subject of the emergence of new ideas about passive investing that focus on new approaches to the construction of indexes. Unfortunately, the brilliant Dr. Mankiw makes a hash of it, which I think is a typical result given that most economists of his stature do not make a serious study of capital markets and are far from experts on investing.

There are many problems with GM's analysis but the fundamental one is that he conflates Siegel's rethinking of index construction with a repudiation of passive management as a preferable alternative to active mangement. I think Siegel's "revolution" is quite clearly confined to index construction methodology:

"..traditional indexes will make way for fundamental indexing, which constructs indexes based on measures like companies that pay dividends, rather than just company size."

I don't see much abandonment of the passive philosophy in that. Clearly Siegel thinks that the market can be inefficient at times and in places and he is in very good company. I don't know of even the most ardent Graham & Dodd disciple that completely rejects Efficient Market Hypothesis. Acknowledging the theory's holes is hardly radical and consistent with the empirical evidence - some active managers consistently outperform passive benchmarks. This is where Mankiw makes the fatal mistake. He states: "By contrast Siegel thinks markets are inefficient. But if that is so, why not advocate active money management? The answer is that active money management has not done as well as passive management. But that fact seems to undermine the basic premise of the funds that Seigel is promoting."

No. The entire body of John Bogle's work, and simpatico work by Malkiel and even Swensen himself, lay the blame of active management's inferiority squarely at the feet of the frictional costs and the profits of financial intermediaries such as brokerages and mutual fund companies. Their basic premise has never been that active managers generate worse returns by virtue of their security selection, but that they are mathematically doomed to underperformance after all the frictional costs like bid/ask spreads, commissions, tax inefficiencies and their own profits have been factored in. It does not follow that if you believe the market to have inefficienies, that you must accept these handicaps. Not surprisingly that is not what Siegel advocates, rather he is taking aim at the concept of capitalization weighting and not passive management itself. He is not proclaiming a soon-to-be-revealed secret rule that will beat active managers, but a different approach to indexing which, presumably, preserves its advantage by avoiding frictional costs, but that corrects some of the investment illogic inherent in the capitalization weighting methodology. It makes perfect investing sense to correct for inherent biases that lead one to buy more of what is expensive and less of what is cheap.

That's the core of my criticism of Mankiw's analysis, but I also take issue with the notion that Bogle's view is superior because it has an economic theory behind it. Are we to suppose that our current pantheon of economic theories are sufficient to explain our universe and we should be skeptical of anything which isn't backed by accepted economic theory? I surely hope not. EMH is a very good theory, but yet we know that value stocks outperform growth stocks, so why are the views of Ben Graham not elevated to the state of an economic theory rather than merely the guiding principal of countless practioners? Perhaps the very simple concept of buying an asset for less than its intrinsic value at a reasonable margin of safety should be deemed an economic theory. Surely its historical record of huing to theoretical expectations while still exhibiting some flaws is no less worthy than EMH of the title "economic theory." Actually, scratch that thought. Perhaps it is because value investing is not an accepted economic theory that enables people to employ it become, gee I don't know, the second richest person the USA.

Disclosure: the author makes his living as an active money manager and his clients are some of the most sophisticated and informed investors around. Despite knowing full-well about Efficient Market Theory, they, and numerous others like them, pay good money to avail themselves of active money management services. If they saw no value in it, they wouldn't pay for it and the author would be out of a job. As it is, there is value to certain active management approaches and the author likes it that way!!