Passive investing is eating the mutual-fund industry, as money floods out of actively managed funds and into index funds and exchange-traded funds. “Passive” typically means two things — diversification and minimal trading. Active funds are supposed to make money by concentrating their investments and taking advantage of good opportunities. The case for passive investing is that active investing is a losing game.
Most finance professors will tell you that active management isn’t worth it. The market is just too efficient — efforts to beat it cost time and money but produce little in the way of extra risk-adjusted returns. Better to ride the average with an index fund or ETF than waste time trying to out-think the crowd.
For individual investors — folks picking stocks at home with their own money — the academics are giving very good advice. When retail investors trade, they tend to lose money each time — on average, they’re making bad decisions, and paying trading costs for the privilege of doing so. Only a very small percentage of normal people — perhaps 2 percent to 5 percent — have the skill to consistently beat the market average, after adjusting for risk.
Professionals, however, are a different matter. A large number of studies has documented that the typical mutual fund manager really does have the skills to beat the market on average. Now, via finance professors Lubos Pastor, Robert Stambaugh and Lucian Taylor, there is more evidence that professional money managers are very different from their amateur counterparts.
Pastor et al. look at what happens when mutual funds trade. If fund managers have market-beating skill, their trades should come from spotting real opportunities instead of mirages, so they should make higher returns just after an unusually large burst of trading — assuming, of course, that their trades pay off within a year. Since most money managers are judged on annual performance, that’s probably an OK assumption.
In general, trading isn’t correlated with higher or lower returns. That means that you can’t make more money by picking a fund with higher or lower trading (sorry!). But for each specific fund, higher-than-average trading is followed by higher-than-average returns. That means that although not all trading is based on good opportunities, a lot of it is. When there are chances to beat the market, money managers tend to see them and take them.