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Active vs. Passive Management: The Last Word?

Passive investment management, which means investment in sector and/or asset class indices (usually represented by exchange-traded funds or ETF's) is marketed by its advocates as a solution to a real problem. Most investors don't do as well, long term, as the conventional market measures and most active investment managers tend to perform more or less in line with their benchmarks. So, goes the argument, investors should settle for average performance (that is, index performance) because, on balance, it is vain and more expensive to depend on active management for consistent outperformance.

Well, it sounds credible enough but it turns out that arguments for passive management are flawed. But the flaws have nothing to do with the conventional reason for employing passive strategies.

It is true that most active managers do not outperform their benchmark (which means for example, that if you are a typical U.S. large cap manager your performance will tend to resemble that of the S&P 500; and so on).

It is true that the costs (meaning management fees) associated with active management are generally higher than those associated with passive management.

Incidentally, it is also true that most active and passive individual investors underperform their corresponding benchmark/indices. This is because of the all-too-human tendency to buy high and sell low.

The flaws in the case for passive management are not obvious.

The first has to do with the fact that for most investors, their investment portfolios are actively managed portfolios in disguise. This is so whether you do it yourself or use the services of a portfolio/investment manager.

Why this is so becomes clear when you realize that someone is making a judgement call as to which index vehicles to own, when to buy and sell and in what amounts.

While the index funds making up an investor's portfolio may themselves be managed passively, at the investor level the selection and allocation process requires someone (the investor or the portfolio manager) to utilize classic active management methodologies. All that has happened is that the active component of the process has been shifted from the domain of individual securities selection and allocation to the domain of asset class/sector selection and allocation. Put another way, which securities are owned in a particular ETF is a matter of formula. Which ETF's are owned, which are not, and in what proportion is a matter of discretion.

Thus, there is no diminution of active management risk. All that has happened is that the risk now resides at a different level of portfolio management.

The second flaw is one you could call a flaw of reason or logic.

As it is true that active and passive management performance (given the same style) tends to resemble each other over time, why invest passively where you are certain to achieve the average when you can invest actively and expect to achieve the average, yet have at least the possibility of outperformance?

Active managers have the opportunity to pursue gains and are not locked into non-discretionary positions. If you have the choice between giving your manager discretion to pursue opportunity vs. no discretion why would you think twice? Most active management performance resembles passive management performance. But it's most, not all. It is in the space between “most” and “all” that the potential for outperformance resides.

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