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ON THE MONEY: Active vs. passive investing

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The Efficient Market Hypothesis was first promulgated in the 1960’s as part of Eugene Fama’s Ph.D. thesis at the University of Chicago. He was a recipient of the Nobel Prize in Economics in 2013 for his seminal work on portfolio theory and stock valuation.

His theory, which has been hotly debated since its introduction, holds that is impossible to outperform the market because all relevant information regarding every stock has been perfectly digested by the market and each share price reflects that market awareness. As a result, stocks are always perfectly valued by the overall market, thus making it impossible for investors to sell overvalued stocks or purchase undervalued ones.

Fama introduced two terms as part of his theory: alpha and beta. Alpha refers to the ability of a portfolio manager to generate investment returns that are better than the market or the specific stocks in an index fund. Beta refers to the volatility of a specific stock or index by comparing its performance to that of a related benchmark over a period of time.

The baseline number for alpha is zero, which means that the investment performance equaled that of the market. A positive alpha is good. Beta has a neutral value of one, which means that the price of a stock moves precisely in synch with the market. A beta of less than one is sought after, while a beta of greater than one means that the security’s price has been more volatile than the market as a whole.

Fama held that a positive alpha was, in effect, a short-term aberration which would self correct in time by the overall market.

Fama’s theories, in part, motivated John Bogle to introduce the first index mutual fund in 1975 at Vanguard. This was the first passively managed fund in the U.S. Today, there are more than 1,300 such funds which offer the following advantages:

• Very low fees due to the fact that there is no need to analyze the individual securities that comprise the index that is used by the fund.

• Investment transparency since every investor knows precisely which stocks or other investments are part of the index.

• Income tax efficiency since the fund’s buy and hold strategy does not generate large capital gains.

Actively traded portfolios or funds are managed by investors who buy and sell individual stocks more frequently. Proponents of this strategy point to:

• Flexibility in stock selection, since index funds are composed of a weighted average of stocks that are part of that market sector.

• The ability to engage in hedging of risks (selling short, trading options, etc.)

• Better risk management, since underperforming stocks can be sold when a stock becomes too risky, or a market sector is not doing well.

• Tax efficiencies in a non-qualified account, since underperforming stocks can be sold at a loss, offsetting gains from the sales of winners.

In 2016, investors pulled $285 billion out of active funds, while pushing $429 billion into passive ones — and this year is seeing a similar shift, according to Morningstar. Deutsche Bank estimates passive funds will have as much total money as active ones in three to five years.

About 83% to 95% of active money managers fail to beat their benchmark’s returns in any given year since they bet against the Dow Jones industrial average, and the Dow wins. 

Although recent studies have concluded that active strategies are better in down markets and passive in up markets, passive investing has lower expenses and greater returns over the last 30 years.

The 2021 results narrowed the gap between the two approaches: 47% of active funds outperformed the passive group results.

My view is that it is almost impossible to outperform an index over the long-haul.