In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management. The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.
Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market. Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time. It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.
I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing. It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.
These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.