May 25, 2012

Why Pay for Passive? The Better Question is…Why Pay for Active? – Part One

A new client of Fifth Set Investment Advisors (I’ll call him Jack) was in the process of informing his prior firm (I’ll call them Beat the Market Investments, ‘BTMI’) that he was moving his account from them. BTMI is a money manager strictly in the business of active management (i.e. stock picking in an attempt to outperform the market). During the conversation, the topic of passive investing arose and the BTMI representative quipped “Jack, if you’re ‘going passive’ why pay anyone at all?”

When Jack relayed this conversation, I was struck by the irony of the comment. The representative implied that the value of investment advice is purely in outperforming the market. The irony is that overwhelming evidence demonstrates that active management does not deliver outperformance. In fact the majority* of active managers underperform appropriate benchmarks over time. So the question shouldn’t be why pay for passive but, more interestingly, why pay for active. Why pay to increase the likelihood of underperforming the market rate of return?

I have no idea.

*Of the minority of active managers that outperform their benchmark over extended periods, there is little evidence of persistence so the small percentage of active managers that do manage to outperform in one extended period are not the same managers that outperform in the next extended period.