On active investing and why markets need active investors.

Active investing refers to an investment strategy where the investor engages in trades with the goal of outperforming a given market. The market can be US stocks, international bonds, art, etc. To contrast, the purpose of passive investing is to match the market return. For example, to accurately match the return of the US stock market, a passive portfolio holds all the securities in that market in their respective market capitalization weights (value-weighted index of all assets). This means that if Apple’s market capitalization amounts to 2% of the total US stock market, a passive portfolio tracking that market will have to allocate 2% to Apple.

For the active investor to outperform the market, he/she must deviate from the market. Hence, an investor must hold securities in distinct weights from the market-cap weights. Further, to outperform, the investor will have to overweigh the securities that appreciate and underweight the ones that don’t. These deviations are called active weights. So, think of active investing as having preferences towards certain securities, sector, etc. compared to their relative portions in the market. Those same preferences are most often established by the investors perceived mispricing and differences in intrinsic valuations. On the other hand, the best way to think of passive investing is as a copy of the market capitalization weights that all active managers have established with their preferences/valuations. Notice, any index or manager that is not value-weighted has taken an active position compared to that market. This applies to all the so-called strategic/smart beta strategies, factor investing, equal-weighted indices, etc. The media often confuses the terms passive with systematic/index-based investing. 

Now that we understand what signifies being active and passive, the next important matter to realize is that financial assets are always held by someone. There is no such a thing as an unowned financial asset. What this implies is that for every buyer of a security there is a seller and vice versa. Further, for every overweight of a security, there must be someone that is underweight that same security with respect to the aggregate market. The relative weights of securities in the market are established by active investors since they trade securities until prices reach the active investors respective intrinsic valuations. For instance, if all the active investors suddenly realize that a company is overvalued, they will begin to sell, causing the price to drop until another active investor buys it at their perceived intrinsic value. In this process, passive portfolios will also reduce their weight to the given security due to its reduced relative market capitalization compared to other securities.

Let’s look at the below situation.

Imagine a $1 trillion equity market that consists of 90% ($900 billion) passive investors and 10% ($100 billion) active investors. As we established earlier, the passive investors will just copy the assigned relative securities weights of the active investors taken as an aggregate. To clarify further, the active investors’ community will decide that Apple’s market capitalization should be 2% of the market, Google’s 3%, and so on. In contrast, the passive investors will just copy those proportionate weights for their portfolio. So, what will happen if the active investors were to go passive? For example, one way would be to imagine taking the money from the active investors and investing it passively, which would mean investing the money using the most recent market capitalization weights. We can see what the repercussions will be. Liquidity will disappear, as there won’t be anyone to trade with since everyone will just take the last assigned valuations. The equity markets will be stale, holding the same relative companies’ weights, as there will be no-one to set prices via their intrinsic valuations. 

So, why do we need active managers:

  1. Establish relative valuations of securities: when active managers determine their preference for securities, their goal is to get as close as possible to what they deem intrinsic value of the given security. They will trade until the market capitalization ratios are thought to be appropriate, meaning securities that are believed to be “bad” will not have many buyers, and their market capitalization will be lower compared to securities that are considered “superior”. However, this does not mean that securities will trade at fair-value, since active managers only impact the relative values of securities not the total amount of market value. Let’s say active managers have decided that company XYZ intrinsic value is $100 billion, which represent 3% of the total US stock market. Suddenly, the population feeling optimistic decides to sell $1 trillion in bonds and invest the proceeds in the US equity market (or the government prints a few trillions). Given this new inflow, what will the active managers do? Their job is to invest the money and given company valuations have not changed, they will invest the new inflows in the exact prior relative weights. The inflows do not alter the proportionate intrinsic values and only alter the total values. Company XYZ will appreciate to $30 billion ($1 trillion * 3%). Active managers establish how securities should be valued with respect to each other, but asset class flows determine the total market value/capitalization.
  2. Provide liquidity: active investors provide liquidity when they update their valuations/preferences. As mentioned earlier, every asset or security is owned by someone. Given that, for those assets to trade, people will have to assign different valuations to them. For example, if everyone thought that company A is worth $50 billion, there will be no trading. For a trade to occur, one investor must believe that the corporation should be valued at $48 billion and another to think it should be valued at $52 billion. The active investors through establishing their different “intrinsic” valuations and updating them provide liquidity to the markets. 

To summarize:

What causes the buyers and sellers to trade with each other? What will cause someone to transact anything, not just financial assets? The answer is different valuations, different preferences. I have apples but prefer oranges, and you have oranges, but prefer apples. The idea applies to every market being it a market for fruits, paintings, financial assets, and so on. A market is just a gathering where exchanges take place. If active investors did not exist with their preferences, the financial markets would not exist.