Index mutual funds and exchange traded funds capture more investment dollars every year as the theory of passive investing gains adherents. The advocates of this approach contend that actively searching for the best companies adds costs but little value-so why not buy flDlds that passively and cheaply track market benchmarks? Now, though, a new study by a Norwegian professor pokes holes in the research supporting passive investing and suggests that active portfolio management can indeed be valuable.
Passive investment strategies are based on the idea that money managers can’t consistently outperform the overall market because stock prices evolve randomly. And even if a manager does beat the market, in many cases an investor’s gains will be wiped out by the costs of actively trading equities or other assets-or so this theory asserts.
As a result, passive strategists say, investors are better off simply following market indexes. If the market goes up, their portfolios will rise, and with only nominal trading costs. The most common form of passive investing simply mimics the movements of a specific index by buying index funds, which offer low management fees, good diversification, and low turnover.
The downside to this strategy is that it is indeed passive, and a broad index may not react as strongly to good economic news, for example, as particular stocks in an actively managed portfolio might. Passive investors can miss out when the market trends sharply upward. Also, of course, when an index declines, so will a flDld tracking that index.
Active management is just the opposite-a money manager selects stocks or other assets based on their potential to out perform an index. Such a strategy may result in a more concentrated portfolio that’s more sensitive to economic and market trends.
The new study, “Very Long-Term Mean Reversion and Predictability of the U.S. Stock Market Returns,” was written by Valeri Zakamouline, an economics professor of the University of Agder. Zakamouline shows that while stock prices may fluctuate, they do tend to revert to their long term averages. Zakamouline also demonstrates that long-term investment risk decreases over time and that a period of above-average returns tends to be followed by an equal span of below-average returns.
While the study doesn’t prove that advisors can actually use market predictability to consistently generate returns that exceed market averages on a risk-adjusted basis, it does indicate that the stock market is predictable over the long term. And that is powerful evidence that long-term investing in the stock market will generate positive returns on a risk adjusted basis.
