Active vs. Passive Investing?

This is an ongoing argument that is yet to be resolved:

(and I thought that on the heels of yesterday's blog that this might be an appropriate topic to follow)

• Many academics will argue that the additional trading costs of trying to "out-perform" an benchmark index (and the potential for misses) tilt the case in favour of the Passive argument.
• How then do the passive managers justify their fees?
• Technically, passive portfolio managers should be able to match the benchmark index, before fees and taxes.
• This is referred to as the "Beta", or the expected return.
• Ongoing re-balancing (perhaps quarterly), whereby "over-weight" assets (that have out-performed) are paired back to the strategic allocation weight (taking profit on a portion) and using the cash generated to buy additional "under-weight" (under-performing assets).
• This will add additional potential to return, over time as different assets will out-perform and under-perform over the course of the economic cycle.
• The additional return, above the benchmark return, is referred to as "Alpha".
• An active portfolio manager's goal is to increase "Alpha" with a more active trading regimen, trying to find anomalies in certain assets that have (in their opinion) given them additional value.
• This is how a more active portfolio manager can justify a higher fee.
• In some cases (especially with active "hedge funds") there may be an additional "performance fee".
• It comes down to the argument of "efficiency" in markets: does a market immediately price in all the relevant information or is their a behavioural aspect that makes markets create "inefficiencies" that build anomalies in to a market?
• Further, can a good active manager seek out and take advantage of these anomalies before the rest of market participants discover it?

(click on this chart to enlarge)

Tomorrow I will look into this topic using the arguments presented by "Behavioural Finance"

The views expressed are those of the author, Scott Tomenson, a Raymond James Financial Advisor, and not necessarily those of Raymond James Ltd. It is provided as a general source of information only and should not be considered to be personal investment advice or a solicitation to buy or sell securities. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor's circumstances and risk tolerance before making any investment decision. The information contained in this blog was obtained from sources believed to be reliable, however, we cannot represent that it is accurate or complete. Raymond James Ltd. is a member of the Canadian Investor Protection Fund