Friday, October 21, 2016

Short Takes: Coexisting Active and Passive Investors, RDSPs, and more

Over the past two weeks I managed only one post on the difficult subject of how to determine the best way to invest your savings during retirement:

Prime Harvesting in Retirement

Here are some short takes and some weekend reading:

Lasse Heje Pedersen explains how passive investors are forced to do some trading due to various types of index changes, which creates an opportunity for active investors to outperform. Thus, active and passive investors can reasonably coexist when there are few enough active investors that they can recover their costs from out-trading passive investors. Despite the academic look of the SSRN page, the paper itself is fairly short and very readable.

The Blunt Bean Counter brings in an expert to discuss the Registered Disability Savings Plan (RDSP).

Big Cajun Man has more trouble depositing money into his son’s RDSP. His musing about how difficult it will be to get money out is definitely food for thought.

Boomer and Echo tries to explain to the anti-RRSP crowd why RRSPs are not a scam. I’ve tried to do the same thing with pictures.

Squawkfox settles debates over whether certain items, such as premium gasoline, are a waste of money.

My Own Advisor’s update on his 2016 predictions should make it clear that it’s dangerous to wager real money on such predictions.


  1. Thanks for the inclusion this week. After all the excitement attempting to get money out of the RESP, yes the RDSP might end up being even more exciting... have a great weekend.

  2. With contributions to the RRSP, I think many people forget the "refund" they get is really a government loan - although the government doesn't want to tell folks that. Your pictures in that post help that cause.

    Yes, predictions are fun but I was certainly WAY off in my stock market predictions. That's a good thing.

    Take care, thanks for the mention,

  3. The exchange below is reproduced to remove broken links.

    ----- Richard October 21, 2016 at 11:42 AM

    The paper on active investors is really interesting. One of the biggest risks for passive investors is the active trading and market timing of passive funds.

    It's unfortunate that the financial industry is set up so that there are very few managers with the right incentives to actually deliver excess returns that might be possible.

    Still this does point to the potential for value in other strategies such as buying individual dividend stocks and never selling them. This avoids both the fees and turnover of index funds (as low as they may be).

    In a recent post I saw you added up the total cost of fees from your index funds over several decades. Have you tried to get a good estimate of the cost of the turnover in those funds compared to buying stocks and never selling them? It may be hard to account for the likely outcome that stocks added to the index will be at a higher valuation than stocks removed from the index but it would be interesting to see what effect that has.

    ----- Richard October 21, 2016 at 11:52 AM

    Another interesting result comes from the fact that active investors are comprised of many different groups. If we accept that active performance is not necessarily equal to passive performance on the whole, it's not certain that active investors will do better.

    For example as the paper states passive investors may be forced to trade at any price while active investors can choose what price to accept on the trade.

    This means the price is set by the most willing active investor. And it's easy to see less wise investors funneling money to a manager with bad incentives who provides the liquidity to passive investors far too cheaply.

    In that case there may not be much the wiser active investors can do. They could short a stock that's being bought at too high a price but then they're taking on additional risk.

    This opens the door to the possibility that the average active investor does even worse than the passive investor minus fees.

    ----- Michael James October 21, 2016 at 12:08 PM

    @Richard: Keep in mind is that Vanguard and other index fund companies work to reduce predictable index fund (and ETF) actions that active traders exploit. I don't know whether Pedersen's figures on the advantage an active traders could get are accurate, but they could decrease over time.

    Any time I've looked at directly holding stocks, costs haven't worked out favourably. You're balancing trading costs (adding new money or dealing with a problem holding) versus the cost of inadequate diversification. Once these costs are balanced, total costs work out to more than I pay for the ETFs.

    Don't get me wrong, though. Buying and holding stocks can work out well (with adequate diversification). It's just that I've concluded that I'll do a little better with index ETFs. Most people do far worse than both strategies. I've also concluded that limiting myself to dividend stocks would actually make things slightly worse over the long run due to the reduced diversification (but still far better than most people do with crappy mutual funds).

    ----- Richard October 21, 2016 at 2:34 PM

    Some of the claims do seem like they have simple solutions. If an index fund has a net inflow of cash (including dividends) then it won't have to sell stocks to buy new additions.

    The added diversification is a benefit of index funds that would be hard to match. I can see a little better why some people would prefer to buy stocks directly and hold them for life though.

    As you showed, even a small annual cost can add up to a significant piece of the portfolio over decades.

    If you truly eliminate all of those small costs then you come out ahead. The risk is that you might add new ones in the process. This does make it seem a little more reasonable to argue that there is a potential reward for spending the time to thoroughly research a diversified portfolio of individual stocks.

  4. The exchange below is reproduced to remove broken links.

    ----- BHCh October 25, 2016 at 12:59 AM

    As more and more people turn passive, the advantages of trading will inevitably grow. At that point passive investing will stop growing and we will reach equilibrium.

    I am also hoping that most humans won't be able to beat our ruinous psychology. Perhaps that is why we are seeing so many active ETFs popping up.

    ----- Michael James October 25, 2016 at 8:50 AM

    @BHCh: These two paragraphs are at odds. If we reach the equilibrium point where active and passive investors have equal returns, then that is a sign that there are few bad active investors beaten by their ruinous psychology. My guess is that we will get closer to the equilibrium point than we are now but never reach it.

    ----- BHChOctober 25, 2016 at 1:21 PM

    Equilibrium may not mean equal returns for passive and active. Active means a lot more effort and higher risk and costs, so has to be rewarded better for an equilibrium to be achieved.

    I am hoping that the premium won't grow too large because of human psychology. Index investing is expanding too fast for its own good, but the growing popularity if various distortions is giving us hope.

    What I am saying is that I don't know which way it will go.

    ----- Michael James October 25, 2016 at 1:25 PM

    @BHCh: The equilibrium refers to having the same returns after costs. I don't think we'll get there; we'll likely maintain an excess of active investors. I doubt that index investing will grow so fast as to go beyond the equilibrium point.

    ----- BHCh October 25, 2016 at 2:07 PM

    Equilibrium means counteracting forces are equal. In this case, it means that the fraction of passive vs active stays the same as inflows and outflows balance each other. Who will be making more returns when this point is reached? We shall see.

    ----- Michael James October 25, 2016 at 2:27 PM

    @BHCh: OK, so we were talking about different equilibria. I was talking about the point where active and passive investors make equal returns after costs. I don't think we'll ever get there. You're talking about when passive investing stops growing. That has to come at some point. I suspect that passive investors will continue to earn higher average returns when this happens.

    ----- BHCh October 25, 2016 at 2:57 PM

    Hope you are right.