Abstract
The Efficient Markets Hypothesis predicts that in markets where information is readily available and widely known there are less likely to be profitable opportunities for stock pickers or active managers. In these markets, it makes more sense to use passive investments and forgo the higher fees of active managers. Correspondingly in markets where there is both less quantity and quality of information there will be profitable opportunities for talented stock pickers to buy and sell mis-priced stocks. In these markets, active managers can be well worth their fees.
We examine the Active versus Passive debate himself with an empirical study. We approach this research with the belief that certain segments of the market are highly efficient, especially for large corporate stocks, and should be indexed as cheaply as possible, while others are highly inefficient, such as the municipal bond market. A hybrid approach is recommended utilizing both active and passive investments.
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Notes
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In 1934, David Dodd and Benjamin Graham, Warren Buffet’s mentor, wrote Security Analysis, which came to be known as the foundational book on value investing. Graham and Dodd came up with a method for valuing stocks, primarily looking for deeply depressed prices. They sought out stocks that had a high earnings-to-price ratio, a low P/E based on its history, a high dividend yield, a price below its book and net current asset value. In addition, they wanted to see total debt less than book value, a current ratio greater than two, earnings growth of at least 7% for the past ten years, and no more than a 5% decline in earnings in more than two of those ten years. According to their research, these screening methods were predicators for consistent outperformance over time.
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This was for 92 managers with 240 monthly observations from January 1994 to December 2013. To reduce our four segments to a manageable sample, in large cap growth and value we took only those managers that on a cumulative return-basis outperformed the average of the overall peer group. In international and small cap, we used all managers whose return record was available across the entire sample period. We broke each group into two segments:
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Tier 1 – managers who outperformed the index on a cumulative basis.
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Tier 2 – managers who underperformed the index on cumulative basis.
In large cap core, we had an even longer time frame available of 30 years, or 360 observations.
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Anderson, Tom, “Active fund managers rarely beat their benchmarks year after year”, CNBC, February 27, 2017.
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Merker, C.K., Peck, S.W. (2019). Active Versus Passive: The Evidence. In: The Trustee Governance Guide. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-21088-5_12
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DOI: https://doi.org/10.1007/978-3-030-21088-5_12
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Publisher Name: Palgrave Macmillan, Cham
Print ISBN: 978-3-030-21087-8
Online ISBN: 978-3-030-21088-5
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