A Passive Investing Movie

I highly recommend having a look at a 54-minute movie called Passive Investing. The discussions are mostly non-technical and fairly easy to follow. They even cover the lifestyle advantages of switching to passive investing. For more details about this movie see Canadian Couch Potato’s description.

What prompted me to write a post about this movie is an issue that is more technical than the film itself. Canadian Couch Potato made the following remarks about the movie’s mention of the capital asset pricing model (CAPM):

“CAPM—which predicts the expected return of a security based on its beta—is still widely taught, but it doesn’t do a particularly good job of explaining returns in the real world. (The Fama-French three-factor model is a dramatic improvement.) So I’m surprised the film’s website describes CAPM as ‘the mathematical foundation of passive investing.’”

He is right that the three-factor model is better at modeling past investment returns than CAPM. However, what matters is the future and not the past. The important question is what features of past returns will persist into the future?

We can devise ever better models of past returns by adding in more factors, like momentum effects over certain durations and reversion to the mean effects over other durations. In the extreme, we can just take the entire database of past returns and call it a model. This extreme model exactly matches the past, but future returns for each stock will not exactly match past returns.

So we return to the question of what features of past returns will persist into the future. For CAPM to be useful, we need the risk premium to persist. Over the long run we hope that a diversified portfolio of volatile assets will continue to earn higher average returns than safer investments. In my opinion, it seems like a safe bet that people will continue to prefer safe investments and will be willing to pay a premium for them.

Fama and French modeled the fact that small-cap and value stocks have enjoyed higher returns than their riskiness would indicate using CAPM. Do you believe that small-cap and value premiums will persist into the future? Maybe there are good reasons why these premiums will persist based on human nature. But this seems less certain than the persistence of the risk premium. Certainly, if enough investors were to embrace the three-factor model, it would eventually erode the returns of small-cap and value stocks.

With my own portfolio, I’ve cast my bet on the risk premium and partly on small-cap and value premiums. So, in this sense I agree with Canadian Couch Potato. But I wouldn’t say an investor was wrong if he chose not to count on small-cap and value stocks to outperform in the future.