Arguments that are frequently heard in favour of passive strategies include: “80 per cent of fund managers don’t beat their selected benchmark index” and, “Just buy the Beta because there are two few managers around that can constantly find alpha and it’s too expensive in any event”.

I have never understood the argument that says by using an active manager you only have a 20 per cent chance of doing better than the benchmark, and that passive is far better than active management. However, with a passive strategy you would have zero chance of doing better than the benchmark.

A long-standing argument between value investors (Warren Buffet) and the likes of Gene Farma et al has been raging for decades. The scientists/academics who brought us the pseudo science of alpha, beta, CAPM and all the other lovely useless scientific measures of risk and return now argue that alpha is non-existent, when previously it was possible to achieve alpha but only with undue risk. The all-time flaw of Farma’s work is the Efficient Market Hypothesis. It is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier assets. One stumbling block that blows this theory out the water at every debate is that it does not explain stock market crashes.

I would argue that the over-riding factor against any of the professors and their academic theories would be their collective venture into the Long Term Capital Management debacle, which nearly brought down the US economy.

All the attention to passive investing, I believe, was mistakenly read by the “passive-only” crowd, when Warren Buffet, whom I believe is the best investor of all time and the largest proponent of value investing, said publicly that the average retail investor would be better off buying an index tracker rather than using an active mutual fund manager. I think most serious investment managers would not argue with this comment.

This, however, does not warrant the flight to passive. The reason for the average mutual fund manager not beating the benchmark is not because it is impossible or extremely difficult to do, but rather that most of these funds are either closet index trackers in any event or the fund managers may trade excessively and by so doing  increase their total expense ratio.

Who is the manager?

First of all I must say that I have never seen the reason to let a life company manage money.  I would certainly not ever buy life insurance from a fund manager. Most true fund managers only have one or perhaps two strategies, more than this and they are not focusing. More importantly, it is now proven that human behaviour is ultimately the largest single factor behind average and excellent investment performance. This behaviour includes individual and institutional behaviour biases. 

To me, common sense would suggest that if the market is a collective measure of human psychological behaviour (being both greed and fear) then buying this roller-coaster of behaviour completely flies in the face of the argument against active management. For if most of the return from investment is a product of behaviour, then relying on 100 per cent of your return to be provided by an out of control collective psyche seems ludicrous.

The passive punters argue that in the stock market the price on any given day truly reflects that value of the quoted company. Again this flies in the face of the behaviour argument and mostly certainly against common sense. If today a company with £100 million in the bank is worth £10 per share and tomorrow it is quoted as GBP15 per share, its value is simply a product of human behaviour in over valuing (bias) the company because sentiment is ‘good’ and people feel positive. There is no intrinsic value increase in the company, i.e. there is no more cash in the bank than yesterday.

Therefore choosing to invest purely in passive investments is not an effective investment solution. Following a passive strategy is not really passive as the allocation and fund/index selection still needs to be done. The underlying fund may have various methods of indexing and may have human intervention. I would argue that passive investing can only be done at times when the market, index, commodity or “thing” you are trying to buy is either undervalued or underpriced. For example, a basic metric such as the FTSE100 index priced/valued on a P/E of 10x or a weighted P/B of 1x.

So what we have now is that passive investing squarely relies on market timing and/or tactical asset/sector allocation strategy. It is widely known that tactical asset allocation largely does not contribute to long-term performance. For if the passive-only pundits argue that it is impossible to pick a stock that will outperform then how do they propose to pick an asset or an index that will outperform?

I don’t believe that active and passive are mutually exclusive and that either is wrong or right. I use passive collective investment vehicles together with selected active funds.  Care needs to be taken when to invest only in passive investments, remembering that the fundamental element in any investment transaction is the difference between cost and sale value. Using passive only requires absolute assurance that you are at rock bottom prices to protect your downside.

Value investing protects you in two instances. Firstly, if you are investing in or around a company’s net book value (i.e. its liquidation value) then you are at least assured that your capital will be returned if the company ultimately fails and goes into liquidation. Secondly, by always buying a company at a discount (typically 33.3 per cent) to its intrinsic value (known as the investor's ‘margin of safety’) then you are eliminating most of the downside risk should the company earnings fail to materialize in uncertain times to sustain the business.