This measure considers changes to the ETF portfolio composition excluding those that arise from inflows and outflows. The real question shouldn’t be about choosing between active vs. passive investing, but rather, utilizing a combination of both if you have enough assets to do so. Since passive investing often performs better during bull markets and active investing can outperform in https://www.xcritical.com/ bear markets, the best course of action may be to combine the two, which gets you the best of both worlds. For the average investor, passive investing might work better because of the lower fees and the fact that you don’t have to make decisions about which stocks to buy or sell. Multiple studies spanning decades have demonstrated that in the long run, passive investing beats active.

Unless you are picking the stocks yourself through an online brokerage account, actively managed funds are much more expensive than passive funds that track an index. Some examples of passive investments include exchange-traded funds that track an index like the S&P 500 (SP500) or Dow Jones Industrial Average (DJI) or mutual funds. Second, the model shows how to decompose this overall inefficiency into the inefficiency of the market portfolio, the inefficiency of other factor portfolios, and that of truly idiosyncratic micro bets.

For a recent model of agency issues in asset management, see Buffa et al. (2020). A risk-adjusted return represents the profit from an investment while considering the risk level taken to achieve that return. Controlling the amount of money that goes into certain sectors or even specific companies when conditions are changing quickly can actually protect the client. Active investing is a strategy that involves frequent trading typically with the goal of beating average index returns.

This is true in international equities, where the median active fund manager outperforms by over 1.5 percentage points per year. That’s a return well worth the customary fees of active management, and the same holds true in small-cap investing. Between passive and active investing, the best investing style for you depends on your goals, risk tolerance, time horizon, and experience. Beginners are more suited for a passive strategy, such as investing in index funds and low-cost ETFs with a robo-advisor.

Should you Choose Active or Passive Investing?

You can also invest in actively traded mutual funds and ETFs, which are pre-established investment portfolios based on market data and economic trends. But unlike passively managed funds, active funds are more volatile to the ups and downs of the market. For that reason, active investing is not the recommended strategy for long-term investing goals. These latter trends suggest a new complexity to the competitive landscape in investment management. That ETFs have successfully challenged the business model of the active mutual fund industry is clear. The ability of ETFs to provide both a lower cost of passive investing and new vehicles for alpha-generation introduced a new competitive environment, with lower fees and many more funds competing for investor’s funds.

Further, we show how the costs of active and passive investing affect macro- and micro-efficiency, fees, and assets managed by active and passive managers. Our findings help explain the rise of delegated asset management and the resultant changes in financial markets. As seen in the proposition, we would expect that lower costs of passive investing due to index funds and ETFs should drive down the relative attractiveness of active investing and therefore reduce the amount of active investing, rendering the asset market less efficient. Indeed, a reduction in the cost of passive investing implies a rise in the relative cost of active investing, corresponding to an upward shift in the dashed curve in Figure 2.

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2 Measuring ETF “Activeness”

See also Breugem and Buss (2018), who consider the effect of benchmarking considerations on information acquisition and efficiency with multiple assets, and Kacperczyk, Nosal, and Sundaresan (2018), who consider the effect of large investors’ market power on market efficiency. Next, we illustrate some of the effects of changing costs of passive investing with an example. We use the parameters from example 1 in Section 2, but vary the cost of passive investing to illustrate the results predicted by Proposition 7. Finally, part (d) of the proposition shows that the above three cases exhaust all possible scenarios, under Assumption 1. In other words, Samuelson’s notion of macro- versus micro-efficiency is a good one in the sense that the most and least efficient portfolios are always the factor portfolio (macro) and the arbitrage portfolios (micro), never anything in between. Indeed, we have multiple securities (so we can discuss micro vs. macro) and a precise measure of efficiency for any asset or portfolio given by (4).

• We log the turnover values similar to Bhattacharya and Galpin (2011) to account for the tendency for the standard deviation to increase with the level of market turnover.
• As ETFs evolve into more complex products, and as technology lowers the cost of information gathering, we expect to see both disparate fund flows and fee pressure arising from greater competition between active and passive ETFs and between active ETFs and mutual funds.
• We show that reduced information costs indeed lower inefficiencies consistent with the empirical findings of Biais, Bossaerts, and Spatt (2010) and Dávila and Parlatore (2018), but they actually mostly lower macro-inefficiency (counter to that part of Samuelson’s hypothesis).
• Influential papers focusing on other aspects of asset management include Berk and Green (2004), Petajisto (2009), Pastor and Stambaugh (2012), Vayanos and Woolley (2013), Berk and Binsbergen (2015), and Pastor et al. (2015).
• Stambaugh (2014) in his AFA Presidential Address made the important point that active investing was becoming less active as measured by tracking error and stock holdings.

Samuelson also hypothesized that efficiency, especially micro-efficiency, has improved over time (see quote and reference in Section 3). Such an improvement in efficiency may be driven by a reduction in information costs as information technology has improved. We show that reduced information costs indeed lower inefficiencies consistent with the empirical findings of Biais, Bossaerts, and Spatt (2010) and Dávila and Parlatore (2018), but they actually mostly lower macro-inefficiency (counter to that part of Samuelson’s hypothesis).

A Appendix: Further Analysis and Proofs

The second part, which is more unusual, says that the inverse of the variance-covariance matrix of the supply noise also shares this structure.14 Assumptions 1 and 2 are both satisfied if all shocks are i.i.d. across assets, but otherwise they are different. We focus on Assumption 1, as it is the more standard and more realistic assumption. In particular, the results that require narrowing Assumption 1 down to the case of i.i.d. shocks what is one downside of active investing also hold under Assumption 2, and we therefore state them in this greater generality. (b) fees are set via Nash bargaining; (c) each active manager decides optimally whether to be informed; and (d) each investor decides optimally whether to use an active manager, use a passive manager, or be self-directed. The return of the risk-free security is normalized to zero while the vector of risky asset prices p is determined endogenously.

We also see, consistent with Hypothesis 6, that ETF fees are lower than those of mutual funds (active ETF fees are lower than active mutual fund fees and passive ETF fees are lower than index mutual fund fees). As well, we find support for Hypothesis 4 that fees for passive funds are lower than for active funds (passive ETF fees are lower than active ETF fees, and index mutual fund fees are lower than active mutual fund fees). The results (Model 4 of Table II) also show that more active ETFs tend to have higher secondary market turnover (dollar trading volume scaled by market capitalization). Both activeness in form and function are likely to contribute to higher secondary market turnover but for different reasons. For active in function ETFs (e.g., narrow industry funds), high secondary market trading is a natural consequence of investors using such ETFs as building blocks of active portfolios. For active-in-form ETFs, if investors learn about the skill of the fund manager by observing realized performance, funds should flow from worse-performing funds to better-performing funds, generating secondary market trading of the active-in-form ETFs.

This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Before joining Forbes Advisor, John was a senior writer at Acorns and editor at market research group Corporate Insight.

Selection Strategies

To address any of these issues, we need to measure empirically the “activeness” of ETFs, an issue we turn to in the next section. Third, the model makes predictions on the impact of the ongoing, widespread reductions in the cost of passive management on capital markets and the industrial organization of the asset management industry. In particular, we show that falling fees of passive investing will increase market inefficiency, lower active fees by less than the passive fees, lower the fraction of active investors, and lower the number of active managers. Among the active ETFs, we expect to see a stronger tendency for investors to learn from past performance and chase returns in ETFs that are active in form, that is, where the ETF seeks to generate alpha through active management within the ETF. To test this conjecture, we use a simple proxy for active-in-form ETFs based on the amount of turnover within the ETF portfolio.

The high net worth clients I work with typically require a more diversified allocation beyond stocks, bonds and cash into assets such as real estate, insurance, private equity and other alternatives. The mutual fund holdings data are also sourced in a similar manner as the ETF holdings from the Thomson Reuters Fund holdings database. We exclude nonequity funds, and non-US funds, and funds with fewer than ten holdings or $10m in assets. Adding the Moderately Active ETFs brings the share of these “aggressive–passive” ETFs to 92% of all US equity ETFs.

Comparative statics shows that a one-unit increase in a increases the optimal fee by 1/2 and that this optimal fee is unaffected by b⁠. So, relative to a passive fund run by an otherwise similar manager, we expect the aggressive–passive fund to charge a higher fee. If over time the information the active manger exploits becomes cheaper and easier to incorporate into an investment strategy then the manager’s effective skill parameter, a⁠, should increase and we expect these more active ETFs to grow relative to passive ones. Their relative sizes, however, are determined jointly by the parameters of the model and if these parameters satisfy our assumptions then the passive ETF will be larger than the aggressive–passive ETF.

Falling Costs of Active and Passive Investing

These products and services are usually sold through license agreements or subscriptions. Our investment management business generates asset-based fees, which are calculated as a percentage of assets under management. We also sell both admissions and sponsorship packages for our investment conferences and advertising on our websites and newsletters. In the chart above, you can see how a passive S&P 500 indexing approach compares with the performance of all stock funds (both active and passive) during various periods over the past 30 years, as measured by Dalbar, an independent evaluator of financial performance. A passive approach using an S&P index fund does better on average than an active approach.