Hello Jamie,

Thank you for your enthusiasm for the subject, and for your thoughtful questions. Here are some thoughts about those questions...

* If you accept the logic of your own statement - "...how active investment, in aggregate, must match the returns of the market. And since all investors will, on average, only be able to match the returns of the market, then after cost, they will, once again on average, lose to the market return by the amount of their costs." - then passive strategies will also fail to beat the market by their costs, too. Passive strategies are not frictionless relative to returns and they are a part of the "market," too.

Separately, whatever our definition of risk turns out to be, and as you know I reject volatility, there will be times when the "market" is riskier than active strategies. Most recently in the post-Great Recession environment active strategies outperformed passive ones specifically because active managers knew it was okay to hold cash, sell riskier companies, make choices based on valuation, and so forth.

My point is that if we agree that a return vs. risk relative to a performance expectation, net of expenses is our standard of evaluation then there is nothing about that equation that says that active managers cannot beat passive managers. However, in that framework, and as most analysis of managers is done, passive strategies get a free pass on the risk frontier. Passive strategies certainly beat on fees, and that is another story and a legitimate question to raise of the active management community. But why isn't it possible to have active returns in excess of the market? Which brings me to my next answer and point.

* You used the word logic in the following way, "...I find alluring the logical [not empirical] argument of..." There are two logics that can be considered: abstract and practical. Your statement relies on the abstract/"in a perfect world" kind of logic. I surmise it is something along the lines of the oft-heard and quoted statement that "the market is, by definition a zero-sum game." That is, in an abstract sense certainly true.

However, let me illustrate by example the important distinction between abstract and practical logic. I notice in your e-mail address a flying/driving reference, so I hope this example resonates. By abstract logic there is no reason to test the performance of an airplane/car in a wind tunnel, or to have test flights/drives, or any form of testing, because in a perfectly abstract, logical sense we understand the mathematics of aerodynamics and forces of nature. We know the plane/car will fly/drive. Of course, hopefully, the error in this logic is obvious.

Practical logic suggests that we cannot solely rely upon mathematics and abstract logic for evaluation. Why? Because the world is far more complicated than our equations would seem to indicate, logically (and abstractly). Instead, everything engineered has variances and tolerances built into it because we recognize, what? That the world is far more complex than we can acknowledge through pure abstract logic.

Put another way, practical logic will always trump abstract logic. Why? Because practical logic is more inclusive than abstract logic. Because of its inclusiveness of practical considerations, practical logic proves it is inclusive of abstract logic. That is, abstract logic is a sub-set of practical logic. The reverse, in the extreme, cannot be said. In fact, the entire reason for using abstract logic is to simplify the world and to the degree to which we gain illumination from the simplification. This, by the way, is one of the reasons why we had a 2008-2009 financial crisis: models built on abstract, not practical logic.

So with that preamble let's return to your point about the (false) deity of finance and economics: The Market. I would argue, and I think I would win, that no one has transparency into the abstract concept of "The Market" that is necessary for the argument: "the market is, by definition a zero-sum game." What qualifies here as "The Market?" If the S&P 500 is "The Market" - as it is for many, then all that is necessary to violate this as a proxy for the "The Market" is to identify some asset not in the index. What if we take every equity on the planet and put it into an index called "The Market." OK, so now what if I buy a single fixed income instrument? Then clearly the "all inclusive" is not. So now we construct an index that is all equities everywhere and all fixed income everywhere. But what now happens if I buy some options, or short some options, or I have art, or gold, or a patent, or an education that I can monetize into money, or...hopefully you get the idea.

Yet, there is more. There are two assumptions underlying the abstract logic of "The Market" that no one ever discusses. The first assumption is that everyone in "The Market" is fully invested. If I have any amount not invested - not even in a money market security, just a currency amount living as an electron in a bank - for even one down period that exceeds my fees, then I beat "The Market." The second unspoken assumption: everyone is invested always. If there are any time lags in my portfolio, like I retire or I die, then I am no longer invested, and if this happens in a down period and this period is of sufficient duration then I can justify my fees.

In short, where is this "The Market?" Using abstract logic, I know exactly where this "Market" is because by definition I can say something tricky like, "The Market is anything in the entire world that someone might want to exchange something of her's for." That "The Market" I understand, but practically, where is this "The Market?" How do I buy it? If the S&P 500 is my benchmark, not my investible universe (see last month's post), then all I have to do to beat the index is to buy an S&P 500 ETF and buy one asset that goes up by more than the fees I charge. Alternatively, all I have to do is to buy an S&P 500 ETF and short one stock even within the S&P 500 that goes down by enough to cover the fees I charge. OK, you say, but the S&P 500 is not "The Market". Whatever you choose as "The Market" all I have to do to beat it is to identify one asset outside of that definition that outperforms to justify my fees.

* Next, it is not an oft-covered topic, and in fact, to my knowledge I am writing of it here for the first time, but there is not just a "market" for returns, there is also a "market" for risks. Why can't an active manager beat "The Market" when he gets the choice of which returns to buy in "The Market" and also which risks to buy in "The Market?" By definition, "The Market" includes the full suite of returns - the part that defenders of the passive community like to discuss, but what they don't discuss is it also includes the full suite of all of the risks of "The Market." Ouch! I don't like that kind of symmetry. I would much prefer a unit of return in excess of a unit of risk, wouldn't you? With "The Market" you get it all.

* I am not sure if you read my piece from last month about the bizarre concepts meant to enforce an odd definition that forces everyone to toe the benchmark line, but if these concepts are abandoned, then the world I just described above is much easier. Since we engaged in abstractions above, let's engage in another one: Imagine a world in which active managers are actually active managers and they manage for the equation I described above, "a return vs. risk relative to a performance expectation, net of expenses is our standard of evaluation." One of the reasons I have undertaken this article series is specifically to address the bizarre state of the investing world in which we find ourselves. There is no quick solution because the problem is a lack of thoughtful, conscious engagement with the world on the part of the investment community over the course of many decades. I believe that the active management community has hell to pay (see future articles, and last month's, for example), but that does not mean that adjuncts and passive management get a free-pass either.

* You are entirely correct to point out that the average investor cannot identify the outstanding manager. But is this the problem of the active manager, or the problem of the investor and his/her advisor? I would argue that the individual investor bears most of this responsibility. I think that our industry has done a poo-job of helping individual investors identify quality investments designed to help them achieve their goals. But this is outside the scope of what I am writing about here. Also, until we get the evaluation of these things correct in terms of philosophical foundations, how can we with confidence point investors toward anything with any sense of certainty?

Now some questions back at you...What are your definitions of: "index," "passive," and "the market?"

Yours, in service,

Jason