Chapter 5: The Active versus Passive Debate
INTRODUCTION Within the fiduciary finance industry and academe, the ‘active versus passive debate’ subjects the economic merits of active investment strategies to continuous and unrelenting scrutiny. This empirical research originating in the mid 1960s questions whether fund managers can add value compared to the market averages. The consensus emerging from this voluminous literature is that active management is economically suboptimal because it delivers inferior returns compared to market indices (which are unmanaged). Moreover, learned financial economists assert that active management must underperform market indices after the costs of management are taken into account.1 These arguments have achieved considerable intellectual momentum and, as a result, the economic rationale of human judgment2 in portfolio management has been queried within academic, practitioner and consumer spheres. Without the specter of this debate, many stakeholders would be likely to adopt a pragmatic view that active portfolio management is essential given differing client constraints, and especially since market indices do not measure investment merit or quality. Without a rebuttal to this formidable challenge, only index-tracking strategies (which mimic indices and have very low operating costs) appear to have any economic justification. Fund managers promoting active management strategies face potentially significant revenue losses if clients adopt index-tracking schemes: confirming the merits of active portfolio management remains a commercial imperative. The debate has deeply paradoxical and contradictory underpinnings. Within the theoretical framework, the literature is used to validate the canon of ‘informational efficiency’ and related beliefs that security prices reliably discount all publicly available information. As Fama (1965)...
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