In 1975, John Bogle started the first index mutual fund on the theory that active management does not produce consistently superior returns to justify the added expense. Is this argument consistent with the Efficient Market Hypothesis? I will argue that the idea of “passive management” is misleading due to the practical nature of implementation. There exist only varying degrees of active management with different costs, risks, and expected returns. While it is necessary to question what strategies are worth the cost, the question of active or passive management assumes that there is an identifiable difference between the two choices. If you believe that there is a passive strategy, please leave a detailed description so that I can reply with the active management components that it contains.
The primary problem with measuring performance is that you must first define “the market”. However you define the market, it must be investable directly through an index fund, ETF, or individual assets and this is where the problem occurs. Suppose that you track every company listed on every exchange and you decide to hold a proportional number of shares in each to construct a market capitalized weighted average. In order to maintain the proper weightings, you must constantly buy and sell stocks that are often illiquid. Assuming that the trading fairy solves the liquidity problem, there are still practical limits on what to define as a sufficient change in the market that would justify rebalancing. If we assume that all international equities are part of the market, do currency fluctuations trigger a rebalance? If we segment the market by national boundaries, how do we account for multinational companies or companies where the majority of assets and primary operations are located in another country? In order to answer these questions, indices are created and maintained by various organizations such as Standard and Poor, Dow Jones, or MSCI. The rules are never perfect but if the index is successful, we can infer that industry considers it to be good enough. The rule set can be interpreted as a policy portfolio because it defines what assets will be held, under what conditions assets will be exchanged, and the frequency and methodology of rebalancing. The goal of active management is to simply construct a better rule set than the index.
If you are an asset manager that is benchmarked to one of these indices, you typically have several advantages over the index. The first is the frequency with which you can alter the portfolio enabling you to react faster to new information. The second is the portfolio construction methodology. An index rule set must be predictable which means that the rules that govern whether an asset is included must limit discretion and focus on objective measures such as market capitalization or industry. While a manager may be constrained, they are typically allowed more freedom to choose assets that do not conform to the index inclusion criteria. The manager may also choose assets based on criteria that has been proven to produce superior performance. Few indices are rebalanced based on fundamental business performance. Finally, by underweighting assets, the manger can effectively short an asset relative to the benchmark. This allows the manager to outperform the index regardless of market direction.
Given these advantages, the ability to beat an index using an enhanced index strategy is the result of sufficient work combined with prudent risk controls. The difficulty arises when you determine the amount of outperformance necessary to justify the added expense of active management. While scale certainly matters, the overriding factor is the correlations between individual assets in the case of a single asset class portfolio or the correlations between asset classes in a multi-asset class portfolio. Correlations among asset classes are typically lower than correlations between assets in the same asset class, so the value add of active management is greater for asset class selection than individual asset selection within a diversified portfolio. In a concentrated portfolio, each asset represents a greater portion of asset class selection relative to asset selection. Producing superior returns from a concentrated portfolio requires greater skill in individual asset selection because each asset must outperform its asset class in order to beat a multi-asset class benchmark.
In Part 2 I will discuss some practical examples of active management in a multi-asset class framework using data over the past 20 years, how this relates to the EMH, and what it means to investors.