Should we choose to make our investments actively or passively? While the arguments are fast and furious on both sides, there is a place for both active and passive–the marketplace for investment management is evidence enough of this.
My goal is to propose a structure for thinking about the arguments and counterarguments, and to enrich the discussion by exposing a middle ground between them.
Let’s look at the three main considerations of the debate. The first is that of market efficiency. If we truly believe that the market is informationally efficient, an active manager cannot add value and perhaps we should simply go passive. Most of us believe that the market is not totally efficient, however, so we need to dig more deeply.
The second consideration requires discriminating between skill and luck. To go active, we need to be convinced of our active manager’s consistency and skill. We need to do this ahead of time and we need to believe that the skill will persist, or at least that we will be able to identify when it deteriorates. This is the most complex pragmatic issue of active investing.
Having identified the skillful managers, we come to the third consideration: If the active benefits are high enough and the costs are low enough, then go active; if the costs are too high, then go passive. Costs typically include risks, taxes, fees, and transaction and trading costs. Excess performance–alpha–is a primary benefit, but there are others that are not so easily measured. It is harder to evaluate benefits and costs when they are not quantifiable or even explicit.
In the Beginning
There are two objective premises which both sides will probably accept. The first–a formal argument–is the arithmetic of active management. In the January/February 1991 issue of The Financial Analyst’s Journal, Bill Sharpe crisply articulated this theorem: “If active and passive management styles are defined in sensible ways, it must be the case that: Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar; and after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions hold for any time period . . . and depend only on the laws of addition, subtraction, multiplication, and division. Nothing else is required.”
By definition, passive provides the return of the average dollar invested in the market. Some active investors will do better than this average and some worse. The average active dollar will underperform passive because of costs; the higher the costs, the poorer will be the performance. In a more efficient market, the distribution of active investor returns will be tighter. In a less efficient market, there will more opportunity for a skilled active manager, and there will be a greater downside from a poor manager. This holds in inefficient markets and over any time period.
The second argument uses empirical data. Many researchers work with data on past performance of a set of managers to study the issues. This data is often useful, but must be interpreted with care. For one thing, such data usually has a survivorship bias. It is also not unusual to define the “index” as the S&P 500 and to use this to evaluate managers who select securities outside this universe of stocks, or to equal weight rather than to cap-weight managers when averaging their performance. This is not “sensible” averaging in the words of the theorem. Any study that shows the performance of a set of active managers outperforming a passive average mathematically must have issues with survivorship bias, ill definition of the average, or some other data issue.
But while empirical studies are useful, they will not be the focus of this article. Instead, we will focus on the three main considerations identified earlier.
The concept of market efficiency is a useful construct in economic theory, but is not to be taken literally in real markets. I am after a pragmatic rather than a theoretical discussion.
The use of the term “passive” is perhaps unfortunate as it has the negative connotation of being inert, of offering no resistance. The active advocate sees passive as being “information-less.”
This is too extreme for the passive proponent, who observes that prices encapsulate the wisdom, information, and expectations of a vast amount of market intelligence. This is a powerful concept, underlying capital pricing and investment management. A passive investor can exploit the prices that are set by the active investors, even if he believes that market inefficiencies exist. To beat the market, he points out, one needs to add something that is not already contained in these prices.
The active advocate is not comfortable accepting consensus prices, since doing so is too close to believing in market efficiency. He does not trust them. How can a market that drops 5% or 10% in one day with no real news be efficient? A decision to accept consensus prices means giving up his individuality and decision-making capability. Most people he knows are not rational. How then can the market prices be correct?
Market efficiency is a key conceptual discussion as it highlights the fact that opportunities to add value are not easy or obvious. But this discussion does not directly address our question. A belief in market efficiency may be sufficient for going passive, but it is not necessary.
Searching for Alpha Managers
In evaluating manager performance, it is difficult to distinguish skill from luck. Noise and uncertainty are high. The more efficient the market, the harder it is to identify skillful managers and the more costly it is to search for alpha.
Certainly, a large number of bright and eager participants spend time and money searching for opportunities or anomalies. As a result, opportunities in most publicly traded markets are rare. Those that exist quickly become unsustainable as other investors observe and imitate. Finding them becomes harder all the time.
The active advocate’s first argument is typically his past performance. This doesn’t cut any ice for the passive proponent, who observes the poor historical record of most active managers. In order to succeed, the active manager must be better than the best managers, not better than the average. He points out that in any population of active managers there will always be a winner and that a lucky break is easily spun as evidence of skill.
The honest active advocate counters thusly: Here are my specific ideas; I have found the following opportunities; I believe I have outstanding skill that will persist; and I will convince you of this. Those who are in the business of selecting managers will similarly try and prove their skill. The less honest will, with a smile, presume clairvoyance.
While factual and measurable, past performance is of little relevance to this discussion. Not everything that can be counted counts. There is little empirical evidence that past performance persists.
The winner of the search is the manager with the best active story. To the passive diehard, the active manager can never satisfactorily prove his skill because even the greatest success can be explained by luck. On the other hand, the active champion’s promise of skill cannot be absolutely refuted.
For the sake of argument, let us suppose that we have found an active manager and we have a compelling case for where his edge is coming from. We then need to move on to costs.