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Active vs. Passive: Man or the Market?

Many academics consider the active-vs.-passive debate settled. Yet, despite the strong evidence supporting a passive, index-like approach, many investors still assume that skillful active management can increase returns, net of costs. The basis for a prescription of a passive investment strategy rests on scientific inquiry in the field of finance rather than on anecdotal evidence or 'good-sounding' stories told by the active mangers, media, supposed gurus, or others spouting investment pornography.

The tests have been done and they are well documented. Unfortunately for many investors, the subjects of these tests are not lab rats, but real people with real money! Below are some common questions that can help clarify this debate and hopefully help you not to fall victim to the higher costs and subpar performance of active managers.

Q: If an active manager can gather information and gain insight or knowledge through research into a company, shouldn't he be able to beat the market?

A: Not necessarily. You and I could have a different set of information or a different interpretation of the same information, while other investors may have no information at all. However, neither of us is at an advantage or disadvantage because the aggregate of all information is already contained in prices. So, rather than gaining insight or knowledge, the manager is simply gathering information the market has already digested.

One way to look at it is that in order to beat the market with skill rather than luck, you don't just need to have more information and insight than the "average" investor. You theoretically need to have more information and insight than all investors combined.

An active manager has only two arrows in his quiver—market timing and stock picking. All nuanced forms of active management ultimately boil down to some combination of these two elements. Both fundamentally rely on predicting the future, and the information presented in support of the forecast is typically quite compelling. Statements are made such as "we think the price of oil will rise because . . ." or "we think the economy will recover next year because. . . ." No matter how convincing the case may seem, however, you should always ask why this information that is readily available to the market would not already be reflected in prices.

Q: If market efficiency implies prices are right, then doesn't the fact that some stocks being 80%-90% below the level they were priced at a year ago challenge this fundamental premise? Which was the right price—today's price or the one a year ago?

A: The short answer is that both prices were probably wrong, but both prices were also your best estimate of the right price!

Market efficiency is not based on the premise of prices being "right" but on them being your best estimate of fair value. All prices may be wrong; but for markets to be inefficient, the errors would have to be systematic and identifiable. You, or your active manager, must also be able to identify these errors when other investors cannot, since your profit must be at someone else's expense. Not every investor can win in a zero sum game! However, the mistakes are mostly random rather than systematic (some prices are too high and others are too low), and there is little persistence in the ability of active investors to exploit these pricing errors.

Besides, the fact that prices can change dramatically is not a sign of market inefficiency. This is a reflection of how quickly prices can adjust to a new equilibrium based on the latest information.

Furthermore, there is a dilemma facing active investors who believe that pricing errors are identifiable for profit at the expense of someone else. If the price is wrong today, how can one be sure the market will eventually arrive at the "correct" price in the future? Is the market inefficient today but efficient tomorrow, or is there a chance an investor will go to his grave as the only one who knows the right price?

Q: How can you say active managers won't beat the market when I just read about XYZ Investment Company, which has outperformed for the last twenty years?

A: We can't say there aren't any active managers who have beaten the market in the past, and we can't say there won't be any active managers who will beat the market in the future. What we can say is there haven't been, and likely won't be, any more than you would expect by chance. The problem isn't that there are managers who have beaten the market; it is that there are too few of them!

Let's assume there were 5,000 funds available for investment over this twenty-year period. The 95th percentile of the distribution of outcomes from this sample (i.e., the top 5%) would represent 250 managers with a twenty-year history of generating returns that are significantly above market. At that point, you may be thinking, "what more proof do I need than 250 managers over twenty years?!" What you need to consider, however, is that if you had 5,000 proverbial monkeys managing portfolios by throwing darts at stock pages, you might observe even more than 250 who would have generated returns that put them in the top 5% of manager returns net of fees.

The monkeys would have clearly been dismissed as just being lucky, even over a twenty-year period. However, many investors are unwilling to dismiss the superior returns of an even smaller number of managers as being largely due to luck over the same time frame. I can't say for sure that it is all luck, but what I can say is that the outcomes don't look much different than if there were no skill at all. For many investors, hope springs eternal, but in my opinion investment dollars shouldn't be invested based on hope but time-tested, scientific research.

As a result, your example of XYZ should only be viewed as anecdotal evidence, and we do not want to implement an investment strategy on that basis. Let's say you had a very serious illness for which a doctor was prescribing treatment. Would you be comfortable following a treatment plan if you asked the doctor for the basis of his diagnosis and he responded, "it worked for my last patient"? Probably not, as you likely want to hear about years of scientific tests examining the whole distribution of possible outcomes, both in and out of sample, as outlined in top-tier medical journals subject to intense scrutiny, refereeing, and peer review. Why expect anything less for your financial health?

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