Index funds have seen their assets under management balloon in recent years as investors have increasingly abandoned active investing strategies in favor of locking in the "market return" by tracking a widely followed index.
However, while the rising tide of passive capital flows may look like a threat to active managers, it has actually made active investing more important than ever, in my opinion.
Free riders, not free lunches
The performance of the market as a whole is ultimately the result of the innumerable individual actions of countless active market participants who, in aggregate, determine the price of each and every security. This is the key to efficient price discovery, and one of the fundamental functions of a working capital market.
Index funds do not really contribute to the process of price discovery. Their job is simply to mirror what the market does without any consideration for how or why the market does what it does. Index funds have always been free riders in the stock market.
Index funds' success has been the product of mirroring the overall performance of the market, which has allowed them to outperform most active strategies consistently. Yet such relative outperformance is only really possible thanks to the work of other market participants.
The arithmetic of active investing
The apparent underperformance of active management compared to index funds is something of a mirage. The famed market economist William Sharpe observed three decades ago that, while active strategies' aggregate underperformance is an inescapable consequence of the "arithmetic of active management," it is not a credible argument against disaggregated, individual active strategies:
"It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor's actively managed funds."
In other words, while passive strategies may net out ahead of all active strategies combined by achieving the "market return" year after year, individual active strategies can beat said market return under a myriad of circumstances. One need only look at Warren Buffett (Trades, Portfolio)'s track record at the helm of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) to see that it is indeed quite possible to beat the market for long periods of time.
My verdict
In any given year, some active strategies win while others lose. But it is this very asymmetry that drives the process of price discovery on which passive strategies ultimately rely. Consequently, as the amount of capital controlled by active managers dwindles, the importance of the remaining active capital is magnified. That may be a heartening piece of news for the many browbeaten value investors still plying their trade.
Disclosure: No positions.
Read more here:
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