Study Debunks Another “Active vs. Passive” Myth

by on November 3, 2009

The active versus passive management debate has been raging for decades, and isn’t likely to be resolved at any point in the near future. Academics and investors have amassed mountains of evidence indicating that, after the consideration of fees, passive strategies nearly always outperform active ones (sign up for our free ETF newsletter for the proof). But many have have argued that active strategies may be preferable in certain situations. Thus a “compromise” in this ongoing debate was reached: passive indexing strategies are best for large stocks but active strategies can work better for small cap equities.

London Stock ExchangeThe logic behind this theory goes something like this: the market for large cap stocks is extremely liquid and efficient, eliminating any potential to derive excess returns through diligent research or screening. But in less liquid (albeit still highly liquid and efficient) markets, the smaller number of participants and less widely-disseminated information makes it possible for dedicated stock pickers to outperform.

“This idea pops up frequently in conversation with financial planners and is the basis of common advice about how to invest in mutual funds,” writes Karen Hube. “The problem is, this conventional wisdom has been largely debunked, and investors who abide by it could be hurting their returns over time.”

A recent study completed by William Thatcher of Hammond Associates actually reveals that a larger percentage of active large stock funds beat their benchmark than do small cap funds. For the decade ended in 2007, 61% of active managers benchmarked against the S&P SmallCap 600 trailed their index, while 60% measured against the large cap S&P 500 failed to beat the index.

The results of the study do, however, indicate that active management may beat passive strategies in certain situations. According to the study, indexing tends to beat active strategies in the top-performing asset classes, while active management wins out among the worst performers.

But before we chalk this one up to active management, consider a likely explanation for this phenomenon. Active managers are often guilty of diluting the purity of their benchmarked style by expanding holdings beyond the strict limits imposed. For example, a large cap manager may add some mid caps, while a mid cap manager may throw in some borderline large and small cap stocks.

There’s another reason why these results don’t necessarily argue for active management: in order to benefit from this “rule” an investor must be able to correctly identify the asset classes and styles that will be the best and worst performers – something that most can’t accomplish with any degree of consistency.

Active management will always have its supporters (and there will always be investors who are able to consistently generate alpha through active management). But there are numerous studies, including the recent work done by Thatcher, that indicate most investors would be better served by using ETFs to construct their retirement portfolio than actively-managed mutual funds.

Disclosure: No positions at time of writing.