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Why the arguments for passive investing don't work
by Keith Robertson on Feb 11, 2010 at 08:40
Proponents of passive investing maintain that markets are efficient and that the empirical evidence demonstrates active managers, in aggregate, fail to outperform the market. But their argument is flawed, intellectually dishonest and does not account for the success of managers who, free from a constraining mandate, are able to demonstrate their skill consistently.
The passive advocates say we should be content to accept something close to the available market return, and buy and hold the market forever.
The efficient markets hypothesis (EMH) developed by academic Eugene Fama is used to back this up.
Efficient markets theory
The theory includes the assumptions that in an ideal market all investors will behave rationally and that all relevant information is freely available and instantly reflected in a share price.
Advocates of EMH take data from a highly specific part of the market: active managers who are benchmarked against major equity market indices. They then extrapolate it as evidence for a wider claim that no manager can expect to beat any market and that any form of market timing is always doomed.
This view misleads advisers and needs to be challenged.
Suppose the EMH had never been invented and yet there is still evidence of managers in aggregate failing to beat their benchmark. What might be a rational explanation?
Large numbers law
According to the law of large numbers, if you put a group of people of broadly equal skill into a room they will eventually tend to cluster around the average. It would be entirely rational and inevitable that over time a manager will find it all but impossible to do better than match the average. They are all working with effectively an open book, as all retail fund managers have to regularly disclose their portfolio composition.
A fund manager who finds an ‘inefficiency’ or other winning strategy will quickly be copied and the advantage eroded. This is arbitrage, or common savvy, and it has been around for centuries. If the manager is successful, money floods into the fund, the increase in assets under management may become a drag and performance tends to struggle. Over the long term, say 25 years and more, it would be all but impossible for a star manager to maintain their ascendency.
However, as soon as a manager loses the yoke of being constrained and benchmarked to an index, trying to beat both it and competitors, they can break free and fly.
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