Interactive Investor

Active versus passive: a brief introduction

We explain a key concept investors need to understand in the active versus passive debate.

11th August 2020 11:39

by Tom Bailey from interactive investor

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We explain a key concept investors need to understand in the active versus passive debate. 

To get to grips with the debate between active and passive investing strategies, the key concept to understand is the Efficient Market Hypothesis (EMH). In its most simple form, the theory states that markets fully (or efficiently) price stocks to reflect all known information, making identifying underpriced stocks supposedly an impossible task.

While the theory had some precursors, it started to take hold in its modern form among academics studying finance in the 1960s and 1970s, primarily in the United States. Academics looking at the performance of funds compared to the index as a whole noticed that most actively managed funds failed to beat the average return of the overall market (that is, the return of major indices such as the Dow Jones or the S&P 500).

This was not supposed to happen. The promise of many investment funds was that with their superior knowledge, research capability and skill, they could identify the stocks likely to produce the best returns, in turn providing superior returns to their investors. Instead, however, evidence suggested they performed worse than the market average.

One of the theories that emerged to explain this was the so-called Efficient Market Hypothesis. As mentioned, the basic premise is that stocks prices reflect all already known information, hence it being “efficient”. Therefore, any future movement in price will be the result of presently unknown and unknowable information. As a result, investors are unable to identify in advance the stocks that will go up the most with any degree of certainty.

The reason this emerged, the academics argued (and still do), was the increased professionalisation of the market. Taken all together, the professional fund managers and investment managers compose almost the entirety of the market. Thousands of analysts were poring over the same information and data, meaning that stocks were rarely mispriced. Any potential risks or opportunities were said to already be “priced in”.

As Peter Bernstein, an investment manager in the 1960s notes in his book Capital Ideas: “We failed to recognise that the movement of increasing amounts of money into professional management, a process that was so rewarding to our own pocketbooks, would make it just that much more difficult for us to capture rewards for our clients’ pocketbooks. We could not beat the market because we were rapidly becoming the market.”

On top of this, owing to the professionalisation of the market, alongside advances in communication and trading speeds, any new information is almost instantly reflected in market prices. 

Asset managers can sometimes provide outperformance. However, they can do so only by taking on more risk, such as loading up on high-risk equities or running a much more concentrated portfolio. Some argue that taking on more risk and seeing higher returns is itself a sign of skill.

However, many advocates of EMH would respond by saying that we should not confuse luck with skill. Disentangling the two is tricky, but the fact that no fund manager is able to consistently take such risks and provide high returns, they argue, is revealing.

Enter index funds

EMH took a while to gain currency and is still not fully accepted by many people today. However, the implication for the asset management industry was revolutionary. If active managers are unable to consistently beat the market, what is the point of paying their fees? Surely a better strategy would be to buy the whole market?

It is no coincidence, then, that the first successful index fund available to retail investors was launched in 1976 by Jack Bogle, as part of his new company, Vanguard. Eventually, this index fund saw growth in assets and provided strong performance, gradually winning over converts. Vanguard is now the second-largest asset manager in the world, with the majority of its assets in index funds and Exchange Traded Funds (ETF). ETFs were launched in the early 1990s. In contrast to index funds, ETFs can be traded throughout the day. In practice, for most investors, however, the difference between an ETF and index fund is minimal. 

Irrational exuberance

Many investors and academics have attacked the theoretical underpinnings of the EMH, pointing out that the intrinsic value of stocks and their price often do diverge and the market (at least in retrospect) has irrationally priced certain stocks. 

There are many examples of where this has happened. A favourite to cite is the tech bubble of the late 1990s, which saw investors bid up the prices of internet companies with little to no earnings. At the time, highly intelligent market commentators were arguing that technological advances meant that these high valuations actually made sense. Most famously, two commentators wrote a book entitled Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. By 2002, the Dow Jones had fallen below 8,000 points and, at the time of writing, the Dow Jones’ peak is around 29,000.

Another favourite of more actively minded investors is to point to the bubble in Japanese equities that formed in the late 1980s, before deflating in the early 1990s and failing, even today, to recover. Likewise, the financial crisis of 2008 is upheld as an example of markets not being efficient in pricing various assets, including bank stocks, insurance company stocks and mortgage-backed securities.

So clearly the market is not always efficient or rational. Sometimes price and “fair value” widely diverge and investors who buy at the top of the market get burned.

The few fund managers who have correctly predicted big-market declines exist, but they are hard to identify ahead of time.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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