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Aswath Damodaran, in his excellent paper “Value Investing: Investing for Grown Ups?”, asks whether spending time researching a company’s fundamentals (“active” investing) generates a higher return for investors than a comparable value-based index (“passive” investing)?

Says Damodaran:

Of all of the investment philosophies, value investing comes with the most impressive research backing from both academica and practitioners. The excess returns earned by stocks that fit value criteria (low multiples of earnings and book value, high dividends) and the success of some high-profile value investors (such as Warren Buffett) draws investors into the active value investing fold.

But does spending time researching a company’s fundamentals generate higher returns for investors than a passive index? Does active value investing pay off?

A simple test of the returns to the active component of value investing is to look at the returns earned by active value investors, relative to a passive value investment option, and compare these excess returns with those generated by active growth investors, relative to a passive growth investment alternative. In figure 17, we compute the excess returns generated for all US mutual funds, classifed into value, blend and growth categories, relative to index funds for each category. Thus, the value mutual funds are compared to index fund of just value stocks (low price to book and low price to earnings stocks) and the growth mutual funds to a growth index fund (high price to book and high price earnings stocks).

Shocker! Active value investing mutual fund managers would be better off buying the index.

The results are not good for value investing. The only funds that beat their index counterparts are growth funds, and they do so in all three market cap classes. Active value investing funds generally do the worst of any group of funds and particularly so with large market cap companies.

Damodaran has a great conclusion:

If you are an individual value investors, you can attribute this poor performance to the pressures that mutual funds managers operate under, to deliver results quickly, an expectation that may be at odds with classic value investing. That may be the case, but it points to the need for discipline and consistency in value investing and to the very real fact that beating the market is always difficult to do, even for a good value investor.

Source: Active Vs. Passive Value Investing: How Much Is Your Time Worth?