Active management is increasingly decried as an emperor without clothes. Empirical evidence is typically cited to show that the performance of most active managers is persistently below that of the market; that it is difficult to find those who might outperform; that the few who do rarely maintain their winning streak; and even for proven long-term outperformers it is tricky to separate luck from skill.

Perhaps it is no wonder that index funds and exchange trade funds are gathering assets fast. Yet active management offers many benefits for investors, though these are poorly understood.

Much of the attack on active management focuses on the difficulty of outperforming a market benchmark and the relatively high cost in attempting to do so. However, investment performance for most investors depends on a much longer value chain than just security selection and beating an index.

Investment professionals try to understand the investment objectives and risk tolerance of investors. They translate these into an investment policy with risk and return goals, define an investment philosophy and process, select an appropriate performance benchmark, choose an asset mix, determine ways to select securities to populate the portfolio and allow for course adjustments in response to results and changing circumstances of the investor.

In other words, there are many active management decisions that determine investment outcomes. The influence of security selection may be of limited significance.

We should remember that investors typically underperform their investment potential by not saving and investing regularly, by not matching the investment risk of their portfolio to their natural risk capacity, by not diversifying sufficiently, through poor market timing (“buy high, sell low”) and many other common mistakes. Passive investing cannot address most of these pitfalls. Instead, good investment counselling and active management decisions are needed to mitigate the biggest threats to investment performance.

The contribution of active management in aggregate is equally substantial.

In competing for outperformance, active managers seek relevant information, analyse it to determine value and select securities accordingly. In the process, they help to set prices that impound publicly available information and reflect the expected risk of investment. The efficient allocation of capital in our market-based economy relies on this mechanism.

In addition, the search for superior performance results in the exertion of discipline on the management of underlying enterprises, both through the market for corporate control and shareholder engagement.

In comparison, passive investors are relative free riders, having to pay only the marginal cost of market participation as price takers, rather than the higher average cost for making fair prices and supporting the real economic purpose of financial markets. The resulting silent transfer of wealth and benefits from active to passive investors allows passive investment management to charge lower fees for its products.

While passive investing can have great value in controlling the cost of security selection, active security selection and active portfolio management can produce deeper and more pervasive benefits for individual investors and the wider society.

Active security selection catalyses value generation in the real economy; it protects all investors by efficiently setting security prices and providing trading liquidity; and it offers the potential for better risk management for individual investors.

More broadly, active management, which spans the many decisions needed to produce desired outcomes, helps investors to reach their personal investment objectives, such as retirement security. Big risks can be more easily managed. And as if by magic, resources can be transferred across time. All this could not be achieved passively. The trend in active management towards more comprehensive investment solutions properly addresses investors’ complex needs.

It would not be an exaggeration to claim that the wealth and welfare of investors and our society depend a great deal upon the success of active investing.

Nitin Mehta is managing director of the CFA Institute for Europe, the Middle East and Africa

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