1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #85!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio In this episode, we will discuss with Raymond Kerzerho, PWL’s Senior Researcher about a recent research paper from Morgan Stanley entitled “ Who is on the Other Side”.
Enjoy!
2) ACTIVE VS PASSIVE – WHO IS ON THE OTHER SIDE OF THE TRADE:
François Doyon La Rochelle:
So welcome back to the show Ray. Today, we're unpacking a heavy-hitter report from Morgan Stanley called Who's on the Other Side. It's all about the tug of war between active and passive investing.
James Parkyn:
Well, Francois, this Report is about the current state of Capital Markets and tries to answer the big question: Are markets still efficient? In other words, has the game changed? We know that Passive has significantly outperformed active. Despite that, we read a lot about how Active managers are now going to have the upper hand. We also read about how passive is dumb money with investors trading blindly. Finally, we read that the weight of mutual funds that are invested in indexes is over 60% in the US.
So, with all the noise being published, we thought it would be timely to share with our listeners our views on Active vs Passive. First, I would like to refresh our Listeners about our Investment Philosophy: we are evidence-based and rely on the science of investing. The evidence continues to be very clear: Passive beats active. Buy, hold, and rebalance is the best option for individual investors. It's more tax-efficient. You're much more likely to better manage your emotions and stay the course in difficult times.
Markets. You are also more likely to capture the returns Capital Markets offer over time. So, it's really timely to talk about what is passive. Does it still make sense?
The Title of this Report is subtle but also key to the message. I often share with clients the fundamental notion that markets are not like a credit balance in a bank account, that effectively. When you're selling, there's a buyer on the other side. So, if you think for a minute, you can ask yourself what the buyer knows that I don’t. And the flip side is also true: if you're buying, then you've got to have a willing seller at a price that makes sense to you. So that is the unique perspective of the authors of this Report. Michael Mauboussin and Dan Callahan are really addressing that core concept of who is on the other side of a trade in today's markets. There are institutional players, retail investors, sovereign wealth funds, day traders, hedge funds etc. All these traders help make the market efficient to varying degrees.
François Doyon La Rochelle:
Yes, James, I agree this is a great topic. To make sense of all this, we have invited our colleague Raymond Kerzerho, PWL’s Senior Researcher, Head, Shared Services Research, to join us today. Raymond, before we get into the meat of this topic, I believe that the authors of the Report are Michael Mauboussin and Dan Callahan. Those guys carry some serious weight in finance, don't they?
Raymond Kerzerho:
Absolutely. Mauboussin is a titan in behavioral finance and decision science. He currently works at Morgan Stanley Investment Management. He is also an adjunct professor at Columbia University in NYC and has written several books on financial decision-making. He and Callahan have worked together for years across firms like Legg Mason and Credit Suisse.
James Parkyn:
So I guess they're basically like Batman and Robin of the investment research world, right?
Raymond Kerzerho:
Exactly. They're longtime collaborators, and in this paper, they analyze investment management through the lens of the efficient market theory.
François Doyon La Rochelle:
OK, Raymond, can you then give us a bird's eye view here of the report and why we are still talking about market efficiency in 2026?
Raymond Kerzerho:
Of course, François, that’s a good question. The efficient market theory starts in the 1960s with Professor and Nobel Prize laureate Eugene Fama of the University of Chicago.
James Parkyn:
Yeah, well, we have been very lucky to attend many presentations by Gene Fama. He has been a longtime collaborator at Dimensional. He has presented his latest research at the Advanced Conferences we have attended annually since 2003. Raymond, I think it would be a good idea if you started by clarifying what is meant by Market efficiency. The term confuses a lot of people.
Raymond Kerzerho:
Yeah, absolutely. So, going back to the roots of the concept, Fama broke it into three levels. So, there's the weak, there's the semi-strong, and the strong form of market efficiency. In the weak form, current prices already reflect all price data, so studying patterns in past stock prices won't help you. Then there's a semi-strong form. In this case, prices reflect all publicly available information, including financial statements, analyst calls, and other disclosures required by regulation. Finally, the strong form says that prices reflect every piece of info, including private data.
James Parkyn:
Ray, when people hear Market Efficiency, they generally believe that to mean Markets are perfectly efficient. In our experience as portfolio managers for over 25 years, we can safely state that the markets are not perfectly efficient. I would also add that Fama agrees. He has been very clear on that over the years. His view is that it's just that it's in your best interest to act as though it is perfectly efficient. And that's what our Listeners need to remember.
In the Markets, there are Traders of all sorts looking to find pricing inefficiencies all the time. Hedge Funds, Arbitrageurs, all kinds of big institutional players who trade believing they have an edge to take advantage of other Investors.
The reality is that the evidence shows that active managers have not been able to beat Passive. Francois, we addressed this on our Podcast #83 in January when we reviewed the Market performances for 2025. 2025 was actually a great year where Active managers could have beaten the Market. Larry Swedroe wrote about this. He pointed out that 2025 was a prime year for Active managers to win because there was so much dispersion, where there were big differences between highs and lows in stocks. Active managers are supposed to buy low, sell high, right?! Given a year like 2025, you would think active managers could exploit that and beat the market, but they didn't.
François Doyon La Rochelle:
Beating the market is really what most investors care about, isn’t it, Raymond?
Raymond Kerzerho:
Yes, exactly. But at the same time, and that's really the main takeaway from the paper, is that if you want to beat the market, you must have a competitive advantage over other market participants.
François Doyon La Rochelle:
This leads to the title of the report, “Who's on the Other Side”, because every time an investor buys a stock, someone else is selling it to them.
Raymond Kerzerho:
Exactly, and if you are better informed than the seller, you're probably getting a bargain. Or conversely, if they know more than you, you like you will likely be the one getting ripped off.
If you can't prove you have an advantage, you should probably just buy the market portfolio and go passive.
James Parkyn:
Great.
A lot of this is based on an investor, retail or institutional, being able to assess what the fair value is for a stock, and that requires that you know the future value of the cash flow of a company. And that's not known. It requires forecasting into the future. And then to estimate its value, you need to have a discount rate. What's the appropriate discount rate? Again, it requires forecasting into the future. Active management is selling you the concept that they can predict the future, and we know evidence, very few manages can consistently beat the market over the long term.
François Doyon La Rochelle:
That’s correct, James, it’s very hard to beat the market but Raymond, how hard is it to actually win this game? What does the paper have to say about this?
Raymond Kerzerho:
Yeah, well, in the game of active management, there should be a winner and a loser, right? And winning is much harder than people think. Over the last century, according to the report, only about 2% of companies created nearly 90% of the total wealth in the market. So it's really tough to pick the right stocks. Your odds are very low.
James Parkyn:
Well, again, Ray, we produced a podcast in 2024, #67, when we discussed the research of Professor Bessembinder. His findings are really an eye-opener about the statistics of how few stocks generate the bulk of Capital Market returns. I recommend that our Listeners today go back to that podcast to learn more. Professor Bessembinder’s fundamental message is that there are very few stocks that generate the bulk of the returns over the long term. Active managers must have the skill to find and pick the few stocks that will give them the excess returns to beat the market. Given how unlikely this is, they are more likely to fail.
François Doyon La Rochelle:
Well, yes, the odds of beating the markets in active management are very slim. So, if an investor wants to be part of that 2%, what edges does Mauboussin and Callahan say an investor needs?
Raymond Kerzerho:
Well, Francois, the authors of the report outline four specific categories of advantage. With these categories of advantages, the authors provide investors with a self-evaluation grid to be successful active managers.
So, to be a successful active manager, the first category is behavioral. This means that you are more rational, less driven by emotions than other investors. Maybe you’re more independent-minded: you’re able to resist the urge to follow the crowd when investors are getting overly excited about a trendy stock. Or it may be the opposite: when the market drops like a stone, and everybody is in panic, you are more level-headed, and you can identify the moment to buy at bargain prices.
François Doyon La Rochelle:
Ok, so that was the first category of advantage. What's the second one, Ray?
Raymond Kerzerho:
The second type is the analytical advantage. For example, you may benefit from security that may not be a great deal in the short run, but you are able to foresee that in the long run, it is likely to outperform. Or maybe you just understand a firm’s business model better than most market participants, resulting in a buying opportunity for you.
François Doyon La Rochelle:
And now what’s the third advantage?
Raymond Kerzerho:
Well, Francois, the third category of advantage is informational, in which in-depth research allows investors to uncover valuable information about complex firms that are not easily available to other investors.
Frankly, I find this one quite similar to the analytical advantage, but the authors treat them separately.
Finally, the last one is the technical advantage, which allows you to exploit temporary imbalances between the supply and demand for a security. For example, an investor may excel at studying the short positions in the market, trying to figure out which stocks could be hit by a short squeeze when a particular stock price shoots up because short sellers panic and buy the stocks in a hurry to limit their losses.
François Doyon La Rochelle:
Right.
James Parkyn:
I will try to summarize what the authors propose in the report, they're trying to make a case that Active Managers can beat the Market provided they develop an edge over other investors in all four areas. This means you will need to master a lot of detail and use it to trade and beat the person on the other side, be it buying or selling. It all comes back to forecasting the future. We don’t believe it is possible for anyone to predict the future consistently.
Investors who think they can do it on their own are deluding themselves. The evidence that active managers can beat the market is compelling. Particularly with U.S. equities in the last 15 years, when returns were driven by MAG 7 stocks.
Active managers have professional restrictions on concentrated bets in their portfolio. And when the market itself has become concentrated, that's where you can see you're not going to keep up. I suspect that is why we are seeing that Active Managers will outsmart the market. Ray, what do you think retail investors can master all this stuff?
Raymond Kerzerho:
No, I don't think so. And if I take the view presented by this report, it requires a total mindset shift. You'll stop asking, “Is this a good company? And instead, you're going to ask different questions, such as: who's on the other side of the trade? Why are they, seller? Why are they selling right now? What is my specific edge, is it behavioural, analytical, informational, or technical?
What makes me so special?
François Doyon La Rochelle:
And if an investor is sitting there and he realizes that he does not actually have an edge, whether it’s behavioral, analytical, informational, or technical, he should not be actively trading, correct?
Raymond Kerzerho:
There you go, that’s it. The best thing that an investor should do is to adopt a passive portfolio to capture market returns.
James Parkyn:
We’ve covered this many times on our Podcasts. If you're trying to pick stocks, you may get lucky with your bets. But don’t confuse luck with skill. And the same applies to picking an Active Manager. It's just as difficult to find who's going to be the best active manager and how long the fund is going to operate. Active managers can be effective for a period of time, but how do you know when the secret sauce will stop working? Then you are back to square one to pick another active Manager to beat the market. This reduces the likelihood that you're going to efficiently capture capital market returns. I mean, that's what the evidence says.
So, so to me, Ray, I can't see where an investor or an Advisor would have an edge at picking active managers. Again, I'm going to get back to what I said earlier in quoting Gene Fama, which is that, yeah, markets aren't perfectly efficient, but you've got to behave as though they are. That’s really the important lesson that our listeners should take away from today’s Podcast. By adopting Passive investment strategy, you're giving yourself the best possible chance to capture capital market returns net of the embedded fees and the fees that a firm like ours would charge.
Raymond Kerzerho:
Yeah, I can concur with that. And I would even add that from a tax perspective, passive management or passively managed funds make a lot of sense as well because you won't realize that much capital gains. You really take control of how much capital gains you trigger and the timing of when you're going to.
François Doyon La Rochelle:
Agreed.
Raymond Kerzerho:
You have to pay taxes on capital gains, and being able to control that is a great advantage.
James Parkyn:
Yeah, well, we see that with clients’ portfolios. Especially those who've been with us for a long time. If they're not in the decumulation mode, they've been adding and saving money. The unrealized gains that they have in their taxable accounts are impressive, especially after three recent years of double digit returns in equities. But what is so powerful is that they are compounding returns in pre-tax dollars in a taxable account. The tax efficiency is extraordinary. So not only are we efficiently capturing capital market returns, but in taxable accounts, we're deferring capital gains tax for as long as possible. That said, we are disciplined about staying aligned with the client's risk profile and portfolio long-term asset mix.
Raymond Kerzerho:
Exactly.
François Doyon La Rochelle:
Well, we all know that active mutual funds have a disastrous track record. In Canada, at least 97% of active mutual funds failed to beat their benchmark index over 10 years in every category. We have not reviewed the SPIVA report for 2025 yet, but I doubt it will be much different than in previous years. We will make sure to review it as well as the “Active versus Passive Fund Monitor” from Morningstar in a future podcast.
James Parkyn:
Agreed, Francois. That's always an important Podcast where we share with our listeners the results of the latest S&P Spiva reports about how well active managers have done relative to a passive portfolio. And the statistics have been overwhelming in the last few years in favor of passive.
So, Ray, based on everything the authors Mauboussin and Callahan are saying, is it fair to make the statement that for retail investors with long-term capital, investing passively continues to be the only real option to be tax efficient and to capture capital market returns?
Raymond Kerzerho:
Yeah, totally. In fact, accepting the notion that markets are, let's say, reasonably efficient doesn't mean they're perfect. But it's accepting market efficiency.
It's really a shift in the mindset. It leads an advisor to stop wasting energy on trying to predict where the market is going, which stock is going to outperform.
Which manager or mutual fund manager is going to outperform? You just stop wasting energy on that, and you start to focus on things that really matter.
For clients, I'll give you a few important ones. So, really you've mentioned earlier the risk assessment.
François Doyon La Rochelle:
Ray, how can a financial advisor help investors, or said differently, where can a financial advisor add value for investors?
Raymond Kerzerho:
Well, Francois there's really four things that come to mind. First of all, there's the risk assessment part of the work. So, we must evaluate how much risk an investor should and can actually handle.
Then there's the asset allocation decision, finding the right balance of stocks and bonds. So, you want to have enough stocks to generate returns, to generate higher returns, but you also want to have bonds as well to provide with downside protection and some stability. So, you're looking for the right balance between growth and stability. Then you've got portfolio management. You have to implement the portfolio and rebalance it regularly, execute the trades to keep it on track with the long-term objectives. Finally, and possibly the most important part of it is the financial planning. Advisors need to build with the investor a long-term road map so that the investors can achieve their life goals.
François Doyon La Rochelle:
I believe this is the role every advisor should play. I believe it's the role that we play here at PWL and that James and the team play with our clients, and this has been at the core of what we've been doing since the foundation of the firm 30 years ago.
James Parkyn:
Well, gentlemen, I feel it was a worthwhile experience to update the core investing principle of efficient markets. We know more about where Capital Markets are today, and that it is no easier now to gain an edge over other investors. You will need extraordinary skill, which is a rare commodity, and very deep resources to do the research needed to beat the Market. With all of the various players actively trading in the market (institutions, retail investors, and sovereign wealth funds), the wisdom of crowds will win out over the long term.
The Authors fail to present any evidence that Active management will consistently beat the market tax efficiently. Tune out the noise of the financial press and stick to your long-term investment plan. The passive solution with a globally diversified portfolio gives you the highest probability of a successful investing experience.
François Doyon La Rochelle:
I agree with that. And on that note, we will conclude. I think the review of this report brings a new color, a new perspective to the active versus passive debate, which is interesting.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, Ray for our participation today, I sure learned a lot and I hope our listeners have found this topic of interest.
Raymond Kerzerho:
You are welcome, Francois.
François Doyon La Rochelle:
Also, thank you James for your contribution again today.
James Parkyn:
You are welcome, François.
François Doyon La Rochelle:
So, that’s it for episode #85 of Capital Topics!
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