Active/Passive Passions

by: Douglas Tengdin, CFA

That's the conventional wisdom. Proponents of passive investing claim that the market is efficient: analyzing stocks is useless. All the public information about them is already reflected in their prices. They see the debate between active stock picking and passive index-based investing as a tortoise/hare story, where passive investors are the tortoise and active investors are the hare. And in that story the tortoise wins.

But investing isn't a morality tale. Active and passive investing serve different purposes. Markets are efficient because active investors buy cheap assets and sell expensive ones. If everyone indexed, expensive stocks would stay expensive. And if markets were perfectly efficient, legendary investors like Warren Buffett and Bill Gross wouldn't be able to generate market-beating returns year after year.

There are good reasons why active investing works: companies in trouble can change their strategies and turn things around. Folks who buy them before this happens will profit. And profitable companies tend to stay profitable. Their excess earnings allow them to hire good people who can deliver cash to investors. But it's hard to buy cheap stocks and hold onto high performers. Our behavioral biases work against us.

So academic studies promote indexing as the only rational approach, because active investing is difficult and indexing fees are lower. But these studies confuse price and value. Ironically, the more people index, the less efficient the market becomes-pricing anomalies persist longer. And indexing increases market volatility. It may be cheap to index, but it carries hidden costs.

No, active and passive investing depend on each other. Active management makes the market efficient; passive management puts downward pressure on fees. It's a good thing they're both available to investors. Their competition benefits everyone.