Passive Versus Active Investment Strategy

Does it make sense to adopt passive investment strategy in this scenario.

Rajan Mehta, Executive Director of Benchmark AMC has written in his article published in the Economic Times on Sunday 7th June 2009 that,

“The active versus passive investment strategy debate has two dimensions. The fist is indexing versus stock picking or fund manager picking and the second is stick to your asset allocation versus doing market timing.”

SIMPLE MATH OF MARKET RETURNS -

Let us begin with understanding how the market functions and what famous Nobel laureate William Sharp has to say about it.

The equity market consists of different investors, including individuals, institutions like mutual funds, insurance companies, FIIs, private equity funds, banks and promoters. So if one calculates returns for all investors, the average of these returns will be similar to index returns.

So by definition, all investors can not be above average. Half of the investors have to below average. And when you consider the cost of trading, more than half have to be below index or an average.

This is summarized by William Sharp in his Quote: “Properly measured, the average actively managed dollar must underperform the averagely passively managed dollar, net of costs. Empirical analyses that appear to refute this principal are guilty of improper measurement.”

Summary -

In short, even though some fund managers may outperform the Index in future, it is nearly impossible for the investors to identify them and hence in the current scenario, passive investment strategy through broad market index fund is on of the best things which investors can do for long-term equity investment.