Every investor seems well aware of the on-going debate of active versus passive investment management. ETF and index fund firms have strongly suggested that investors should view active managers as a group as both imprudent and expensive. Active managers are pushing back by suggesting that the trend toward passive investments is speculatively skewing the market.

Most of RBA’s investment portfolios mix active and passive investing (i.e., PactiveR investing), so accordingly we think both active and passive investments have something to offer investors. However, the current debate seems to ignore some important questions:

➜ Why have so many active managers underperformed? Is all active management bad?

➜ How does one know which passive portfolio (or even active portfolio) to buy and when?

Why have so many active managers underperformed?

Is all active management bad?

Past research (including our own) highlights that active management typically underperforms when market leadership narrows (i.e., fewer stocks outperform the benchmark). A few potential reasons help to explain this phenomenon:

1. Narrow markets conflict with fiduciary responsibility – narrow markets imply a tighter concentration of stocks outperforms the overall market index. If managers of broad portfolios similarly concentrated portfolios, they could be chided for not following prudent diversification principles. For example, managers who focused portfolios on the narrow technology leadership during the technology bubble were subsequently considered foolish once the bubble deflated.

2. Broader markets aid those without skill – if one assumes that active managers have no skill whatsoever, then the simple probability of picking an outperforming stock goes up as markets broaden. If 60% of a benchmark’s constituent stocks outperformed the benchmark, a naïve manager would have a 60% probability of picking an outperforming stock. The probability of outperforming under that scenario would be higher than if only 40% of the benchmark outperformed. Because all managers’ skills cannot be above average, broader markets should improve active management performance.

However, actual performance history shows that these are not the only influences. There are cases during which active managers underperform during broader markets (i.e., as they did during 2016). We think there is another explanation.