Active Management is Dead, Long Live Active Management

The Reports of My Death Are Greatly Exaggerated
                                                            Mark Twain

The debate between proponents of passive and active investment management has been going on for years. If the year is good for passive investing, articles cheer indexing and report the death of active management. If it’s a good year for active management, we’re bound to see some articles saying as much. But little is black and white in the investment world. Many aspects of investing are gray. Understanding that and looking back at history is helpful.

The Efficient Market Hypothesis (EMH)
In 1970, while at the University of Chicago, Eugene Fama introduced the Efficient Market Hypothesis theory. In his theory, Fama made the case that since the market immediately integrates all new information into stock prices, there’s no need to rely upon technical or fundamental analysis to identify undervalued securities.  Since he introduced his theory, those who embraced EMH are more likely to believe that passive investment management is the best investment approach. After all, if it’s impossible to outperform the market, why should investors pay a higher cost for active management?

The Tenets of Fama’s Efficient Market Hypothesis
Here is a summary of the Efficient Market Hypothesis with some commentary.

• Investors make rational decisions.
  In 1970 this may have appeared possible. Not anymore! Today, there are immeasurable examples of investor irrationality, particularly when it comes to the way investors react to uncertainty and market volatility. In the 1990s, psychologist Keith Stanovich of the University of Toronto coined the term “disrationalia”, which he explained is “characterized by an inability to think and behave rationally despite having adequate intelligence”. When it comes to investing, disrationalia often causes investors to make decisions that limit their success because in real life, theories don’t dictate investor behavior, emotions do.
• Financial markets are efficient.
  According to Fama, because all information and data are factored into the market, the market is efficient. The question of market efficiency will forever be debated. As you will see below, there’s reason to believe that while efficiency may have been a possibility in 1970, in 2023 it is impossible.
• There is no such thing as an “undervalued” stock.
  At its core, active management is founded on the premise that undervaluation exists. History, and the success of well-known investors like Warren Buffett, have demonstrated that there is such a thing as an undervalued security. To identify and measure relative valuation, it’s incumbent upon you to determine which approaches make the most sense and to help your clients understand the opportunity.
• Securities prices reflect all available information.
  Fama believed that “security prices reflect all available information”. In 1970, there were a finite number of sources of information. That’s far from true today. A few years ago, Scientific American reported that, “In 2016, humankind produced as much data as it had in the entire history of the species through 2015”. If Scientific American is correct, the introduction of the internet, and now AI have made it impossible for all available information and data to be assimilated by the market. We also face the challenge of determining what’s true and what isn’t. These factors weaken market efficiency and open the door to active management.
• There are no transactions costs.
  In 1970, investing was expensive. Investors paid commissions to buy and sell individual securities and were charged a whopping 8.5% “load” to invest in mutual funds. These and other costs of entry required investors to earn handsome returns to make a profit. Yet, when Fama posited there were no transactions costs, he was somewhat prescient, because today, investors can trade securities and Exchange Traded Funds (ETFs) and purchase mutual funds and Exchange Traded Funds (ETFs) without paying a commission or load. But there are still costs associated with investing, mutual fund investments may still incur management fees and financial advisors often charge a fee based on assets under management.
• It is impossible to outperform the market.
  The success of famous investors like Warren Buffett, portfolio managers with stellar track records and everyday investors like your clients who have outperformed the market. Their achievements suggest that it is possible to outperform the market.

Active Management is Alive!
There is no question that Fama deserved the Nobel Prize in Economic Sciences he received in 2013. But 53 years after he introduced his Efficient Market Hypothesis, the changes in the investment world have dramatically challenged the validity of his theory that would lead an investor to believe indexing is the only investment strategy. Given that, it’s safe to say that active management is alive and thriving.