The Efficient Market Hypothesis: The Active Vs Passive Debate
The active versus passive debate centres upon the question of whether markets are efficient.
The Efficient Market Hypothesis (EMH) proposes that company share prices will always incorporate all of the available information and therefore share prices will always reflect what a company is truly worth. Therefore it is not possible to “beat” the market as it is not possible to buy undervalued shares or sell overvalued ones.
An active manager believes markets are not efficient and that this provides opportunities. A believer in EMH would just buy a passive fund, as there is no need to pay the extra costs for no advantage.
The evidence for EMH
Academia has for a long time debated whether the EMH holds true in reality.
Markets are not wholly efficient. Over the past 20 years or so, academics themselves have repeatedly identified inconsistent patterns of returns. These patterns would not exist if EMH represented the complete picture.
Many recognise some specific investment markets as being inefficient. Active managers’ arguments become more powerful with evidence of inefficiency. This at least brings the possibility of gains exceeding the market as a whole. Such inefficiencies may exist in some areas such as smaller companies stocks, poorly researched markets and illiquid investments.
Behavioural finance is one hypothesis that seeks to explain these patterns. It does this by extrapolating the repetitive habits of individual investors which sometimes leads to irrational investment decisions being made. Anecdotally, some funds using behavioural finance techniques, particularly in the hedge fund industry, have achieved some success. Behavioural finance aims to explain occasions when inefficiency is evident.
Indices and trading
Many indices are created by reference to market capitalisation, where each company has an allocation in the index in proportion to its size in the market. Some investors may question the suitability of this process, particularly in the case of corporate bond investment where it involves allocating more money to the more highly indebted companies.
In addition, when a security is added to or removed from an index, it can cause a cluster of trades as passive funds seek to replicate these changes. Passive investors in these instances are obliged to trade, no matter what the price, offering the potential for active investors to exploit these opportunities by buying ahead of a security being added to an index or selling before they are removed.
Typically, actively managed funds are more expensive than their passive counterparts. The greater costs need to be justified by returns in excess of a passive equivalent. Passive funds are cheaper to manage as the underlying construction of a portfolio and the buying and selling can be largely automated. Plus with the growth of passive funds, the fund providers have begun to compete on cost.
In the UK, investors can purchase funds tracking major indices for less than 0.15%. Active funds in the same areas would typically charge between 0.8% – 1.0%. Active funds may also include performance fees, which can have a particularly damaging effect on an investor’s overall return.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.