How an either-or passive versus active stock market investing strategy can impair your portfolio

There’s something happening here What it is ain’t exactly clear I think it’s time we stop Children, what’s that sound? Everybody look what’s going down —For What It’s Worth, by Buffalo Springfield

Over the past two decades, the asset management industry has witnessed a massive transformation during which assets have migrated from active to passive approaches.

Notwithstanding the obvious appeal of passive investing , I believe that most of the debate between active versus passive management misses some critical points. Here, I discuss why active versus passive is not an either/or proposition and how the two approaches are not mutually exclusive. I will also discuss what I refer to as the three pillars of active management : the characteristics that determine whether an active manager can add value to investors’ portfolios .

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In 16 of the past 35 years, the majority of active large-cap U.S. managers outperformed their benchmark. However, there have been environments when active managers clearly dominated passive portfolios, such as the period from 2000 to 2009 when more than 50 per cent of active large-cap U.S. managers outperformed the index in nine out of ten years.

Passive investing is not a panacea. Capitalization-weighted indexes are price momentum-based strategies that are forced buyers of overpriced assets during bubble scenarios. As a result, they tend to do well in rising markets dominated by a few sectors or individual securities. However, this concentration can be very costly during market downturns. There is no built-in buffer or margin of safety and no risk management; just full participation, up or down.

In contrast, active managers are often constrained by individual stock and sector weighting constraints and/or valuation discipline. It is not coincidental that the majority of active managers outperformed during the post-tech-bubble bear market of the early 2000s when unreasonably valued technology ,which were heavily weighted in indexes, suffered severe price declines.