For those of you who often read the financial press, you may have noticed a lot of articles about the recent surge in "Passive" investing versus "Active" investing.
We'd like to re-frame the discussion here and classify investing in three different ways.
"Active" management almost always describes the "Conventional" method of picking stocks. A portfolio manager tries to outguess the market by buying and selling stocks at the right time.
"Passive" investing has described index investing for some time now.
"Evidence-based investing" is an alternate and better approach.
CONVENTIONAL INVESTMENT MANAGEMENT
Attempts to identify mispricing of securities
Relies on forecasting to select "undervalued" securities or time markets
Generates higher expenses, trading costs and risks
Allows a commercially-developed index to determine strategy
Attempts to match an index's performance, restricting which securities to hold and when to trade
Prioritized matching the index over higher expected returns
EVIDENCE-BASED INVESTMENT MANAGEMENT
Gains insights about markets and returns from academic research
Structures portfolios along the dimensions of expected returns
Adds value by integrating research, portfolio structure and implementation
The picture below shows how a well-diversified portfolio can emphasize market areas offering higher expected return potential.
The chart below demonstrates the challenges mutual funds managers face in beating the market.
Dimensional Fund Advisors (DFA) is the leading provider of Evidence-Based Investing solutions. The academics whose research discovered the dimensions of higher expected returns (small vs. arge, value vs. growth, profitability and market exposure) are on the board of DFA and actively involved in further research to discover more dimensions.