Let’s first tackle the issue of information efficiency. With less active management activity, there would be fewer professionals researching and recommending securities. Active management proponents argue it would be easier to gain a competitive advantage. This is the same argument they currently make about “inefficient” small-cap and emerging markets.
Unfortunately, their underperformance against proper benchmarks has been just as great in these asset classes. The reason is that less efficient markets are characterized by lower trading volumes, resulting in less liquidity and greater trading costs. I recently presented the evidence on active management in emerging markets.
As more investors move to passive strategies, it’s logical to conclude trading activity would decline. Yet while we have seen a shift to passive management by individuals and institutions, trading volumes have continued to set new records as the market’s remaining active participants are becoming more active.
However, if, as investors shifted to passive management, trading activity fell, liquidity would decline and trading costs would rise. The increase in trading costs would raise the already-substantial hurdle active managers must overcome. Based on the evidence we’ve seen from the “inefficient” small-cap and emerging markets, any information advantage gained by a lessening of competition would be offset by an increase in trading costs. Remember, the costs of implementing an active strategy must be small enough that market inefficiencies can be exploited, after expenses.
There is another interesting conclusion to draw about the trend toward passive investing—one discussed in “The Incredible Shrinking Alpha.” For active managers to win, they must exploit the mistakes of others. It seems likely those abandoning active management in favor of passive strategies are investors who have had poor experience with active investing.
This seems logical, because it’s not likely that an investor would abandon a winning strategy. The only other logical explanation I can come up with is that an individual simply recognized they were lucky. That conclusion would be inconsistent with behavioral studies showing individuals tend to take credit for their success as skill-based, and to attribute failures to bad luck.
Thus, it seems logical to conclude the remaining players are likely to be those with the most skill. Therefore, we can conclude that, as the “less skilled” investors abandon active strategies, the remaining competition, on average, is likely to get tougher and tougher.
As sure as the sun rises in the east, the proponents of active management will continue to attack passive investing. The reason is simple: It threatens their livelihood. Thus, their behavior should not come as a surprise.
A fitting conclusion is this quotation from perhaps our greatest economist, Paul Samuelson: “[A] respect for evidence compels me to incline toward the hypothesis that most portfolio decision-makers should go out of business—take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.