We all know that indexing is cheaper than active management, in which a fund manager selects specific assets for investment. But the question is why has passive investing been so successful during the past few years? Asked differently, why has active management — especially since the financial crisis — had such a dismal run?
Theories abound — none are completely dispositive, but all have some merit in explaining the reasons for underperformance. Let’s consider each:
Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat market averages.
Hence, even a market that is not perfectly efficient quickly eliminates almost all of the potential alpha, or above-market returns. Being smart, hard-working and savvy may create only a short-lived advantage — or none at all.
• Main Street has given up on Wall Street: The average retail investor over the past 15 years or so has endured the dot-com boom and bust, the housing bubble, a full-blown financial crisis followed by an awful stock-market crash, a whipsawing commodities market and almost zero returns on cash savings. These investors now suffer from finance fatigue and have little interest or faith in anything that Wall Street is selling.
Is it any surprise that many investors, after having been so badly beaten up, have decided to take their ball and go home? And by ball, I mean capital, and by home, I mean low-cost index funds.
• Stricter enforcement of insider trading laws: There’s been a run of finance-industry scandals, a very short list of which ranges from Bernie Madoff’s Ponzi scheme to gaming closing times for mutual funds to spinning initial public offerings. In the past few years, the Justice Department seems to have rediscovered insider trading.
Why? Because it’s a) relatively simple to prosecute; b) there’s often lots of unambiguous evidence and; c) the odds of a conviction are high.
• Internet has leveled the playing field: How much information that once was the province of a select few is now in the hands of all?