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Asness: Why I'm a Cynic of Active Stock-Picking

Scott Burns

Scott Burns: What happens in a world where everyone indexes? Hi there, I'm Scott Burns, Morningstar's global director of manager research. Joining me today is AQR's Cliff Asness.

Cliff, we had you at the Morningstar Investment Conference today, and one of the great questions from the audience was, given everything you think about the efficient market hypothesis and the work Bob Schiller has done, what happens in a world where everybody indexes?

Cliff Asness: First, this is one of the great, kind of, 3 a.m. semidrunken finance doctoral student debates. This goes on. I've thought about this. It's a weird world, of course where everyone indexes. One thing odd about the efficient market hypothesis--and long time ago, Sanford Grossman and Joseph Stiglitz wrote about this in their famous paradox--somebody has to get the information into prices. Once other people do that, it may be the rational thing to buy an index fund, but you are essentially kind of free-riding on the people who got the information into it.

So imagine a world where everyone indexed. Some of my investing heroes, people like Jack Bogle and Rex Sinquefield, will still point out, and they are dead right--this cannot be argued with--that it doesn't matter. The average still can't beat the average. And if you pay higher-than-normal fees for deviating, on average you are going to lose to the average. It's kind of a mangled sense, but I think I got it all right. You can still buy the index, have very low fees, and earn the average return, and the average person who deviates is going to lose to you. That is true.

Having said that, imagine you come along and everyone else is indexing and you notice that Apple is selling for the same price as the corner drugstore that just went public. The market is not doing any research. Everyone's indexing. You can go buy Apple and sell, underweight, or short the corner drugstore, and be it immediately or over time, you will only perturb prices a little bit because the market is very passive, it's indexing. You can take a position.

Burns: Right, you collect the cash flows.

Asness: So we are obviously talking about an extreme we are never going to see, but I think it does move you on to the idea that the more dollars that are chasing inefficiencies, that are chasing mispriced stocks, the harder it is to outperform. I tend to be on the cynical side when it comes to stock-picking. The fewer people who do it, the less cynical I would get.

Burns: I get asked that question a lot, as well, and one of the things that I think people have kind of created a mental model around that's a little incorrect is that, if you are an active manager, the entire portfolio is active, that the whole thing is moving around all the time. But we've run active share studies, and most managers are moving a very small sliver of their portfolios around at any given time. Price discovery actually happens among already a pretty narrow band of people and decisions, right?

Asness: I think that's true. Active is a bit of a misnomer. Active simply means different than the cap-weighted index. In my example, where one person is doing research, and let's call him, overweight Apple and underweight the corner drugstore, the market still has to come after the market. So in some sense, every single other person is a little bit the opposite, is a little underweight Apple and a little overweight the corner drugstore.

And the market, since it comes out to the market, now your new guy who comes in could buy the whole market, and you get the average. But you'd rather be that guy overweight Apple.

In your explanation, there are two dimensions to it. There is how much they deviate from the index and how often they change their mind. So you're kind of using active in two ways at once. And in both of those, it can vary tremendously, but active does not have to mean--a topic I'm going to avoid completely today, high-frequency trading. Active can be very different than the market but hold for very long periods, think Warren Buffett. Active can be fairly close to the market, but imagine you had a fairly fast trading strategy that just tried to add a little bit.

So there are really two dimensions to that and both are legitimate, but I think you're right. Active does not mean a crazy amount of trading necessarily.

Burns: The last point on that. In a world, in this hypothetical world, where everybody does start to index, the value of doing that research goes up, right?

Asness: I think it would have to. I want to be cautionary about this. I've been a long-term cynic, not necessarily that all stock-picking doesn't work, but to invest with active stock-pickers, you not only have to believe that it works, you have to believe you can figure out who has the skill beforehand. So I don't think we're necessarily near a world where it's easy pickings by any means. I am still a net cynic. I have to say, if fewer dollars try, it will get easier.

Burns: It will get easier. Thanks for your thoughts on that, Cliff, and thanks for joining us.

Asness: Thank you.

Burns: And I'm Scott Burns with Morningstar. Thanks for watching.