Passive Investing
A passive investment strategy is based on the belief that the market is efficient and it is difficult to outperform consistently through active management.
Instead of trying to beat the market, passive managers try to match the performance of an index by holding all (or a representative sample) of the securities in the index. The most common form of passive investment is through index funds or exchange-traded funds (ETFs).
Passive investing generally involves lower costs because of fewer transactions and lower management fees. It’s a long-term strategy and doesn’t aim to profit from short-term market fluctuations.
Active Investing
Active investing involves a hands-on approach and requires a portfolio manager or a team of managers to make decisions about how to invest a fund’s money. The goal of active management is to beat the market average, such as the S&P 500 index, and provide investors with a higher return.
Active managers try to do this thorough research and analysis, making forecasts, and using their own judgment to make decisions about what securities to buy, sell, and hold. They may also look to adjust the portfolio in response to market changes or economic trends. This strategy often involves higher transaction costs due to frequent trading and also requires higher management fees for the expertise provided.
Observations on Active and Passive Investment Strategies
Active Investing is a Zero-Sum game and on average active strategies will underperform the market.
Passive strategies will give you market returns. In aggregate, the market will give you market returns. Since the Market Returns = Average Active Returns + Average Passive Returns, it follows that on average, Active Returns also equal market returns less the costs incurred. Therefore, if some active strategies outperform, there must be some other active strategies that underperform.
Most Active Strategies have historically failed to keep up with their benchmark indices. This is true in the US, India, and other parts of the world.
S&P Dow Jones Indices is one of the largest providers of investment indices. They have been doing a comparison of the performance of active versus index or passive strategies for the past twenty years called the SPIVA® (S&P Indices Versus Active) Scorecards. The SPIVA Scorecards compare the performance of actively managed funds to appropriate benchmarks. The SPIVA Scorecards show that:
- most actively managed funds across most categories and regions have underperformed their benchmarks over longer-term horizons.
- the performance of actively managed funds varies across market cycles, regions, and asset classes, but there is no reliable way to predict when or where active management will outperform.
If more people employ passive strategies, will it not become easier for active managers to outperform since passive strategies just follow simple rules to track the market and do not concern themselves with issues such as valuation and investment flows?
If the passive strategies truly reflect the market properly, then no. This is because properly constructed passive strategies will reflect market performance. The smaller active share will remain a zero-sum game and every active winner needs to find an active loser.
There are some inefficiencies in the way indices track the market, particularly around rebalancing which creates advantages for sophisticated active managers at the expense of the passive strategies. These however are small in aggregate in relation to the size and return of passive investments.
Who are the losers in active investment strategies for other active managers to outperform?
Retail investors have been shown to underperform the markets. They are one natural group that professional active investors may be able to outperform at the expense of and some successfully do so. However, as a group, professional investors have been underperforming the market, so this is not enough to sustain professional active strategies as a group. A lot of retail participation is through other professional active investors such as mutual funds and remaining retail active underperformance is not enough given its small size to provide for outperformance of professional active investors as a group.
