What Most Active vs. Passive Debates Miss

From the 1970s, when passive funds first launched, up until today, when their assets under management (AUM) have overtaken those of active funds, the active vs. passive debate has centered on that question.

But this is only one of the issues that investors have to consider. And it’s not the most important. The other considerations are more critical for two reasons: because they help us understand the first principles of the debate and because they elevate that debate from the theoretical to the practical.
When it comes to the choice between active and passive, both the professional and retail investors among us have at least three questions to consider:

Can it be done?
Is it possible for any fund, or any investor, to outperform a market index? Of course. But why is it possible?

Let’s imagine the market is composed of only two stocks of equal size and value, A and B. In a given year, Stock A’s price increases by 20% and B’s falls by 20%. The total performance of the market index is the average of the two stocks: 0%. As active investors, we could have picked Stock A and invested all or most of our money in it. And we could have added more value by shorting Stock B.

Of course, with only two stocks to choose from, we have a very limited number of potential decisions. But what if there were 5,000 stocks and they each yielded a roughly 15% return? Then, even if we did the research, the lack of dispersion of returns would mean we couldn’t add value. So for active investors to have a chance to succeed, performance among securities has to vary widely.

Therefore, a rough gauge of whether active can outperform — of the active opportunity — is the number of securities available in a given market, the dispersion between the best- and worst-performing among them, and the proportion of retail versus professional investors. Big equities markets like those in the United States or India have more than 3,000 listed stocks with huge dispersions between them. So active investors do have plenty of opportunities to add value.

But the number of securities and the dispersion between the best- and worst-performing varies from market to market and from type of security to type of security, whether equities, fixed income, private equity, real estate, or something else. So not all markets are equal. Indeed, in some, the active opportunity may be close to zero.