Active vs. Passive – the debate continues.
The active versus passive asset management debate is ongoing, and despite numerous studies, there remain hardcore supporters and detractors of both approaches. In theory, active management has the potential to produce market-beating returns. The main premise for active management is that information asymmetry exists, i.e… There are inefficiencies in the market. It would therefore be possible to identify undervalued securities and buy or sell them at the right time.
The efficient market hypothesis/theory (EMH) states that a share’s price reflects all available information and trades at its fair value. Therefore, it is impossible to generate alpha, and impossible to outperform the market through active management. Your only solution, when the market is fully efficient, is to invest in riskier assets.
So, are markets efficient? Behavioral finance states that people can be negatively affected by behavioral biases. This is in direct conflict with the EMH, where all market participants view stock prices rationally. An example of this is a 2003 study published in the Journal of Finance. The study examined “the relationship between morning sunshine in the city of a country’s leading stock exchange and daily market index returns” in 26 countries between 1982 and 1997. The study concluded that “sunshine is strongly significantly correlated with stock returns.”
Performance
So, if we assume that markets are inefficient, and therefore provide an opportunity for active managers to seek and achieve potential Alpha, let’s delve into the historical performance of active versus passive and see who wins.
In a report produced by Morningstar across a range of stocks, real estate, and bonds on an equal-weighted basis for the 10 years to the end of 2022, active management only outperformed passive in 5 out of 20 categories. This is reflected in the table below:
Further information from the Morningstar report is that 69% of the actively managed funds in the large-growth category that existed 20 years ago are now defunct, and only 5% of these funds managed to both survive and outperform their average passive peer. This does not bode well for active managers. In the fixed-income or bond space, active managers fared slightly better but still, only 43% of active bond managers survived and outperformed their passive counterparts in the past 10 years.
Interestingly, of the active managers analysed in the barometer over the same 10-year period to the end of 2022, the lower-cost funds either matched or outperformed the more expensive funds in every category. This is reflected in the table below:
Conclusion
There is a place for both active and passive management in a portfolio. The more inefficient the market, the greater the potential return. Whilst the majority of active managers have failed, there are those that have succeeded. Doing careful and detailed analysis and choosing your active managers (without allowing behaviour to impact your choice) is critical. Getting this right is not impossible to achieve above-market returns through active management.
