Just about every claim in the name of active investing is flimsy and refutable, Larry Swedroe says.
I recently read a white paper written by American Century Investments titled “Six Reasons to Emphasize Active Investment Management.” It struck me as having the potential for a little entertainment in exposing the lies behind such stories, so this column puts the six reasons under the microscope. We’ll look at each claim and a quote supporting it, and then go about telling the truth.
Markets Look Forward, Indexes Look Back
“Passive managers buy and hold a security, ignoring any information about either company prospects or market conditions. Intuitively, investing based on that information should benefit active managers. On the other hand, passive investment management—sometimes called index investing—makes no attempt to identify mispriced assets or distinguish between attractive and unattractive opportunities for investors.” Also: “While passive/index investing tracks yesterday’s world, it is active investing that tends to be more forward looking.”
Exposing the Lie
Passive investors do accept that the market price is the best estimate of the right price. Who is setting market prices? They’re set by active investors who are looking forward, paying attention to company prospects and market conditions. And for every active manager that beats the market, there must be another that underperforms. Collectively, active managers must always underperform passive investors in all asset classes and in bull or bear markets because of expenses. It’s just simple math. As Nobel Prize winner William Sharpe points out in “The Arithmetic of Active Management,” “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”