Passive Investing: The Emperor Exposed?
In October 2005, the Journal of Financial Planning published an article titled "Passive Investing: The Emperor Exposed?" by Christopher Carosa. It inspired several letters to the editor, to which Carosa responded and the Journal published (January 2006). In April 2006, a formal challenge was presented by financial planner Allan Roth. To review and assess the challenge, Journal editorial staff convened an Appeals Committee of three financial planning practitioners with expertise in investing and portfolio management. The Appeals Committee met in May 2006 to discuss their conclusions, having reviewed the above-mentioned article by Mr. Carosa, Mr. Roth's challenge to the article, Mr. Roth's letter to the editor, and Mr. Carosa's response to that letter.
To summarize, Mr. Roth's challenge stated that the 2 percent performance difference in U.S. equity funds over the S&P 500 presented in Mr. Carosa's paper was the result of a math error. Rolling periods were weighted using the most current average net assets available, which sometimes was decades after the 12-month rolling period. Mr. Roth's subsequent analysis showed that the practice of future-weighting assets resulted in 75 percent of the 2 percent difference. He concluded his challenge with the concern that the information in the paper would be harmful to financial planners.
The Appeals Committee determined that the issue came down to methodology rather than mathematics. While one may not agree with how monthly return data are weighted, they said, it doesn't mean the math is incorrect. "A 2 percent annualized difference is headline news in the active/passive debate," said one committee member: "People resolve this ongoing issue themselves. But this debate rages on."
Another committee member pointed out that if Lipper did indeed weight the index data as Mr. Roth suggested, two assertions made in Mr. Carosa's paper would be undetermined: (1) that the asset-weighted Lipper data he used "better represents the investment decisions of actual investors" (compared with equal-weighted data) and (2) that he requested inclusion of all active and inactive funds to minimize survivorship bias. The committee member agreed that while it was a potential matter for debate, it was a methodological issue and did not represent an actual mathematical error.
The Appeals Committee encouraged Mr. Carosa to submit new results from his planned re-creation of his original analysis to the Journal. The committee also recommended that Mr. Roth submit a paper based on his own analysis.
[This "Results of Appeals Process" appeared in print in the June 2006 issue of the Journal of Financial Planning. The paper was subsequently retracted, and a retraction was published in the May 2007 issue of the Journal.]