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Readers Select Top Fiduciary Stories of 2009: #9 New Research Reveals When Active Beats Passive

January 12
11:42 2010

When William R. Thatcher published his article “When Indexing Works and When It Doesn’t in U.S. Equities: The Purity Hypothesis,” in The Journal of Investing, (Fall 2009) little did he know of the excitement it would generate among 986868_31811356_White_Heron_royalty_free_stock_xchng_300FiduciaryNews.com readers. His exclusive FiduciaryNews.com interview was the second most read story in the month of November.

This topic tends to generate a lot of controversy. It also generates conflicting headlines. During the height of the market acceleration in mid-year, the media, prompted by a topical Morningstar study, championed the superiority of index investing. Only six months later, the dour decade left passive investing in the dust and active in the ascendancy.

So which is it?

We know a “Snapshot-in-Time” anomaly exists, but that merely leads us to conclude “sometimes active beats passive and sometimes passive beats active.” With the decline of Modern Portfolio Theory as the practicum preferrum and the almost stealthy rise of behavioral finance as the default operative model, sophisticated investors have earnestly begun to search for the Holy Grail – the theoretical basis for determining when active will beat passive and when passive will be active.

Along comes Mr. Thatcher towards the latter half of the year. Thatcher proposed an intriguing idea, what he calls the “efficiency hypothesis,” which suggests indexes tend to outperform during periods of market efficiency while active management seems to do better in relatively inefficient markets. Although some might say the paper is not necessarily a rigorous academic study (e.g., it fails to account for survivor bias and uses Morningstar, not Lipper, data), it does offer a conceptual basis for just such a review. It also has the advantage of appealing to common sense.

For those interested in more on the active-passive debate, you might want to read “Does the ‘Lost Decade’ Signal the End of Passive Investing?” (www.FiduciaryNews.com, January 5, 2010)

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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