Is Passive Investing Defeatist? - J.E. Wilson Advisors

Is Passive Investing Defeatist?

Is investing in a way to capture asset class/market returns akin to “giving up?” Hardly. Passive investing in actuality is about expecting to win at investing over time. Conversely, mountains of research demonstrate that the active manager approach to investing is mostly destined to fail.

Active investment management relies on the belief that a combination of nimble stock selection and market timing will generate returns above those of the broad market (in other words, they seek to “beat the market”). In essence, active management is saying market prices can be exploited. Conversely, passive investment management believes markets are informationally efficient and current prices are the most accurate representation of value.

“Statistically Indistinguishable from Zero”

Many investors confuse luck with skill. In any given year, perhaps 30% of active managers will “outperform” their relevant index. Stretch the time frame to 10 years and the “outperformance” group is maybe half of the first year group. How much of that is skill? Well, a study by Professors Laurent Barras, O. Scaillet and Russ Wermers of 2076 actively managed U.S. equity funds concludes that, after fees and trading costs, 0.6% demonstrated skill at beating the market consistently. As the study puts it, the percentage with skill is “statistically indistinguishable from zero.”

From a practical perspective, investors have to:

  1. Select the manager or fund that will “outperform”, and
  2. Do so in advance – a very, very tough assignment.

Despite these long odds, many investors still continue to “feel lucky.”

The Power of Markets

The Smarter Way to Invest

Research studies conclude that most active funds underperform. In the event that a fund or manager does outperform in a given year, it is unlikely to continue over longer periods. The lesson for investors is to use passive fund managers instead. Lower costs and better returns make this a “smarter” way to invest. Worldwide inflows for passive funds are up sharply over the past few years. Perhaps slowly but surely, the investing public is learning to ignore the predictive views of brokers and other “experts.”

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