Active vs passive: what my ‘moonshot’ research actually shows

The writer is professor of finance at the WP Carey School of Business of Arizona State University

In 2017, I disseminated a research report assessing whether stocks outperform Treasury bills. It seems the report presented something of a Rorschach test, as observers drew starkly diverging interpretations from the same empirical facts.

The paper described long-term investment outcomes to stocks listed on the major US markets. It showed that the majority of individual stocks generate losses in the long run, and that, while the overall stock market increased investors’ wealth by many trillions of dollars, the net gain was concentrated in relatively few high-performing stocks.

One observer reacted by saying that the paper was “another nail in the proverbial stock picker’s coffin” while another interpreted the findings to support “giving yourself the best possible chance of owning a small number of outliers”.

The divergent responses extended to divinations of my own views. One writer pronounced that I argued that “the only way to invest is via index or exchange traded funds” while a Financial Times newspaper headline said I advocated “a shot at the moon”.

So, what did I say in my paper regarding the implications of my research for investors? Rather little. I made note of some new ammunition for each side of the great active versus passive debate, but I did not advocate for either.

Research indicates that it is difficult to improve on the results delivered by broadly diversified index investments. However, this does not imply that all investors should be passive indexers.

Economists have rigorously shown that the financial markets cannot be perfectly efficient, implying that opportunities exist for active investors. Some stocks will at times sell for prices that are low relative to their long run potential and others (even some potential “moonshots”) will at times be overvalued.

One of the most important ideas in economics, in my view, is “comparative advantage” — the simple notion that we differ in the skill at which we can accomplish various activities. I firmly believe that some investors and investment managers possess the comparative advantage to identify misvalued stocks, at least on average. These investors should take positions based on their convictions, in part because the markets rely on them for price discovery.

How many active investors should there be? Consider the somewhat parallel question “how many should seek to become professional athletes?” The potential rewards to pursuing an athletics career can be great indeed. Still, very few have the right comparative advantage, and the vast majority of us should remain focused on our day jobs.

The percentage of the population with the right skills to be successful active investment managers is likely similarly small. The rest of us can consider placing our funds with professional managers. But, how do we tell who has the right skills? In the sports analogy, there can be little doubt that, say, Cristiano Ronaldo outperforms because of skill, not luck. In the investing world it can be harder to say, as business success and stock market outcomes depend in part on influential random events that no one can anticipate.

Even a skilled investment manager will underperform at times, and an unskilled manager can outperform, potentially even for years. Still, the longer the time period over which a given investment manager delivers superior performance, and the larger the investment base involved, the more likely the results reflect skill rather than luck.

It seems inevitable that there will be more investment managers who profess, or even sincerely believe, that they have the necessary skills for long-run success than there are managers who actually have these skills. This consideration points to passive index strategies for those investors who are not well equipped to evaluate investment managers. On the other hand, it makes sense for some investors, particularly those who are larger and more sophisticated such as pension fund and endowment managers, to search for talented investment managers.

I remain comfortable with the sentences that concluded my 2017 study: “The results in this paper imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify in advance such ‘home run’ stocks, or can identify a manager with the skill to do so, remains.”

The writer is also a consultant to Baillie Gifford since 2018