Is investing in a way to capture asset class/market returns akin to “giving up”? Hardly. Passive investing in actuality is about expecting to win at investing over time. Conversely, mountains of research demonstrate that the active manager approach to investing is mostly destined to fail.
Active investment management relies on the belief that a combination of nimble stock selection and market timing will generate returns above those of the broad market (in other words, they seek to “beat the market”). In essence, active management is saying market prices can be exploited. Conversely, passive investment management believes markets are informationally efficient and current prices are the most accurate representation of value.
“Statistically Indistinguishable from Zero”
Many investors confuse luck with skill. In any given year, perhaps 30% of active managers will “outperform” their relevant index. Stretch the time frame to 10 years and the “outperformance” group is maybe half of the first year group. How much of that is skill? Well, a study by Professors Laurent Barras, O. Scaillet and Russ Wermers of 2076 actively managed U.S. equity funds concludes that, after fees and trading costs, 0.6% demonstrated skill at beating the market consistently. As the study puts it, the percentage with skill is “statistically indistinguishable from zero”.
From a practical perspective, investors have to:
select the manager or fund that will “outperform”, and
do so in advance – a very, very tough assignment.
Despite these long odds, many investors still continue to “feel lucky”.
The Power of Markets (Brief Video)