Sometimes, but not always, simple is best.
The desire to best the markets through active investment management perhaps stems from the same intrepid spirit that sent Sir Edmund Hillary to the summit of Mount Everest and Neil Armstrong to the moon. While similar legends have been made trumping the financial markets (think of Warren Buffett or Anthony Bolton), the truth is that, as with any endeavor, there have been both winners and losers along the way. The winners inspire hope among the masses that they too can achieve greatness, while the losers are often forgotten. (In the investment industry this is often referred to as survivorship bias.)
With active investment management appealing to our most basic human aspirations, taking a passive approach to investing may at first seem rather defeatist. While active investors may be looking to reach the top of a mountain or plant a flag on the lunar surface, the passive bunch might be perfectly happy to stay warm at base camp, feet firmly on the ground. But let's move out of the realm of drawn-out analogy and into financial theory to explore the principles of passive investing and how ETFs can fit into a passive investment strategy.
In the Passive Corner
In "The Arithmetic of Active Management," William Sharpe presented a simple and elegant illustration of the relationship between active and passive management that concisely explains why active management can never outperform on the whole. Sharpe notes that a market's return is a weighted average of the returns on the actively and passively managed assets within that market. It then follows that the market return is equal to the pre-expense return on the average passively managed dollar which is then equal to the average pre-expense return on the average actively managed dollar. Taking it a step further, because active managers tend to incur more expenses (high-priced analysts, trading costs, marketing budgets, etc.) than their passive counterparts, Sharpe argues that the average post-expense return on a passively managed dollar must be in excess of the aftercost return on an actively managed dollar.
The intellectual pedigree for index tracking originated with the efficient market hypothesis--championed by Professor Eugene Fama of the University of Chicago--which holds that markets are "informationally efficient." The theory states that the going market prices for all traded assets (stocks, bonds, commodities, etc.) are immediately adjusted to reflect any new information that would affect their value. Within this framework, barring an informational advantage (many of which are likely illegal to act on, unless of course you have a functioning crystal ball delivering you future editions of the Wall Street Journal), the average investor cannot consistently outperform the market.
Economists and finance researchers have questioned the complete accuracy of the efficient markets hypothesis, and its flaws have been magnified by the recent financial crisis. Markets hardly appear efficient when incredible variations in valuation appear over time like the 2008-2009 financial meltdown. Still, it remains extremely difficult to time changes in market sentiment and foresee the confluence of events driving those shifts. The bottom line is that markets have over extended time horizons proved to be fairly efficient and those that have tried to exploit market inefficiencies through active management have proved to be poor market-timers. This basic conclusion has held up in numerous academic studies and in real performance data measuring active managers' collective ability to regularly beat the market.
Why is this? Shouldn't some active managers by virtue of superior skill or sheer luck be able to deliver above average returns on a regular basis? Yes, it is true that in any given time period, there are those who will outperform. The market itself is the sum of all investors--active and passive alike--so it is only natural that there are those who will fall on both the plus and the minus side of the aggregate market's performance. So if there are indeed active managers who have proved that they can best the market, it merely becomes a matter of selecting the right manager, no? No. While some managers will beat their benchmarks some of the time, the persistence of superior returns has been shown to decay fairly rapidly and is owed in large part to the positive momentum of previously selected outperforming stocks rather than a manager's ability to consistently choose new winners (for more on this see the 2000 study published by Chen, Jegadeesh, and Wermers). So last year's winning fund will likely have a difficult time staying on top for long.
Furthermore, on average, any excess expected return generated by active managers tends to get eaten up by their fees. A 2007 study by Fama and Professor Kenneth French of Dartmouth showed that few actively managed funds produce excess expected returns that are sufficient to cover their costs. So any gross outperformance generated by the average actively managed fund will most likely disappear after expenses are levied.
To Be Fair
To be fair, it is not the case that active managers are all terrible stock-pickers constantly chasing the mirage of sustainable market-beating returns. In fact, a recent study of U.S. fund managers argues that many active stock-pickers do regularly outperform the market with a select subsegment of their portfolios representing their high-conviction "best ideas." But shouldn't active managers invest only in their best ideas? We would argue yes, but there are certain factors that prevent most managers from running a highly concentrated portfolio of their most favored names.