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One of the most fundamental and enduring investment debates is over active versus passive management.
Passive investing is based on the theory that markets are efficient and thus take into account all available information about any particular security and price it accordingly. It adopts the view that there is little scope to uncover mispriced securities because prices already reflect true value.
Active investment on the other hand is based on the theory that the market is not completely efficient, allowing smart investment managers to best the market – and a number of managers clearly do so every year.
As the availability of information increases every year, for example, because of advances in information technology, passive investors believe that efficiency will increase and it is becoming more difficult to beat the market.
Passive investors also cite the laws of arithmetic as the average return of actively managed portfolios will equal the return of the market – and thus when you add up costs of trading, administration and management fees, fewer than half of actively managed funds can possibly beat the markets over time.
By buying each stock in an index, or a broad representation of the stocks in an index, passive managers generally deliver returns that match their index, so in theory at least there will be no nasty surprises.
Active management is advantageous given that there is an ability to beat the market, however it is only useful to individual investors if they consistently choose the winning managers. With no systematic or reliable way of ensuring that the choice of active manager will outperform the market, investors can find themselves effectively betting on who they think will deliver the best returns.
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