The choice between active and passive investing has been a battle that has been raging for years, but it can be simplified through a set of easy questions. The answers to these questions are not all together easy, but by forming a direct set of clear questions with a decision tree, the issues can be discussed out in the open. The first question is about market structure and efficiency.
1. Are markets efficient?
If the answer is yes, markets are efficient, then the choice is simple. Invest with passive indices and hold a diversified portfolio. There can be a wide range of answers to the question of what is an appropriate portfolio, but the question of choosing active managers should be off the table. Surprisingly, the market has moved more to passive investing at the same time as more agree that markets are not efficient. If the answer is no, then the investor has to moved to a second question.
2. Are there managers who can exploit market inefficiencies? That is, are there managers with skill?
Markets can be inefficient but that does not mean that all active managers trying to exploit these inefficiencies have skill. There can still be only a small number who actually have the skill of being able to exploit inefficiencies. If the answer to the question is no, then there could be room for specific strategy benchmarks or smart beta alternatives that may be able to exploit some inefficiencies. The spectrum of strategies could include rules-based portfolio that exploits inefficiencies through benchmark at relatively low cost.
3. If there are managers with skill, then the next question is whether the investor can identify the skilled managers or forecast the managers who have skill.
This is not easy because differentiating between those managers with and without skill may take a lot of data and there may be switching between skill managers based on the environment or the strategies that are successful. A manager could be a skilled at value investing but not able to make significant gains during a period when value is out of favor. If an investor does not have the ability to identifying the manager with skill, then he should move back to the passive diversified portfolio.
The conclusion is that any holding of active managers has to be based on the market environment, the quality of managers, and the ability of investors to identify an inefficient environment and skill managers. Since the markets are generally efficient, good managers are rare, and it is hard to find those managers, active management should be an exception not the norm.