Note: This article is courtesy of Iris.xyz
By Joesph Hosler
Within the investment industry, there is an ongoing debate about the efficacies of passive and active investing.
Vanguard has been one of the more vocal participants in evaluating active managers and the consequences of stock-based investment strategies.
Academic research into the matter confirms Vanguard’s hypothesis: Most managers that claim to be active are not consistently adding value to the market return. Each year is pronounced the year that active management will win, but this is rarely the case.
Why does active management seem to be so ineffective at beating the market?
The majority of the investment community attempts to add value by selecting individual stocks. Investors weigh one company or theme more than others. Investment managers spend their time searching for inefficiencies in the valuation of individual companies in order to outperform the market. However, much like any free market, the more individuals focus on finding inefficiencies, the fewer inefficiencies there are to exploit. It therefore comes as no surprise that the significant research staff and budgets of the largest mutual fund complexes are unable to outperform a passive collection of stocks: their size and past success has resulted in an efficient market.
Is the only solution then a static allocation of passive, market-weighted investments? No — inefficiencies will always exist. Therefore, the plan should be to seek out inefficiencies and exploit them. With nearly everyone fishing the same pond for individual company opportunities, it might serve investors to look for fishermen that have elected to change ponds and fish where ample opportunities exist.
Research consistently shows that the two largest components to long-term investment return are market participation and asset allocation. However, very few of the large firms focus on those factors. Instead, they focus almost all of their attention on finding the next Google, Proctor & Gamble, or Home Depot.
This issue was highlighted in a CNBC panel on October 20 th , 2015 with leaders from three prominent mutual fund families. They all promoted active management, focusing on stock selection and argued that 2015 was the year of the stock picker. When the host asked if they ever make asset allocation calls or market participation calls, the CEO of one said they leave that decision to the client. These three large investment firms readily admitted to leaving the two most important investment decisions to the client.
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