One of the biggest battles in all asset management continues to be between passive and active management styles. Passive has continued to win out over the long haul with many proponents arguing that the style plays into the so-called “Efficient Market Hypothesis.” The economic theory concludes that it is nearly impossible to beat the market. And, therefore, active management is a hoax.
But investors may not want to throw away active management just yet.
According to investment manager Thornburg, active management is alive and well. And with that, ETFs could play a big role in helping overcome the efficient market hypothesis and put the debate to rest.
Fama’s Theory
University of Chicago economist Eugene Fama is famous for his work, along with Kenneth French, for developing factor investing. However, Fama is also famous for his work on the creation of the efficient market hypothesis (EMH). In 1970, Fama published a paper called “Efficient Capital Markets: A Review of Theory and Empirical Work.” This set out the theory’s hypothesis.
Under EMH, stocks always trade at their fair value on exchanges. This makes it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices, because the market immediately disseminates all new information into stock prices. So, when material economic data is presented, share prices instantly react.
Under the theory, there is no need to perform any technical or fundamental analysis. As such, passive and indexing is the proper way to build a portfolio as the market acts in an efficient manner.
Data seems to support this theory. Over long stretches of time, passive funds have beaten actively managed ones. This has only expanded today, as EMH is one of the reasons why the growth of ETFs, index funds and passively managed mutual funds has grown to trillions of investor assets.
Not So Fast
But, investors may not want to discard active management for their portfolios just yet – that’s the essence of a new missive from investment manager Thornburg. According to the manager, many of the main tenets of EMH are starting to chip away and active has plenty of power to perform.
For example, Fama summarized that investors are rational in their decisions. This was quickly proven to be untrue, particularly in today’s world of meme stocks and investors willing to bet big on “all revenue, no profit” tech start-ups. Moreover, the study of behavioral finance is riddled with examples of investors acting irrationally and not at all in an efficient manner.
Another point is that undervalued stocks do exist. We can clearly see this in various metrics such as book value, P/E, P/S, etc., that some stocks are cheaper than others – and successful investors can and do exploit these sorts of inefficiencies. The power of Warren Buffett and Berkshire Hathaway is given as an example by Thornburg.
Another point in rejecting EMH, Thornburg shows that while Fama suggests that “security prices reflect all available information,” today that isn’t true. Back in the 1970s, there were not that many sources of information. However, today, with the birth of the internet, rise of social media and other ways investors digest information, it is nearly impossible to understand all points of information. At the same time, trying to determine what is real and what is fake adds another layer of complexity to the situation. This makes active management a winner.
According to the latest Morningstar Active/Passive Barometer, actively managed mutual funds and ETFs – 8,212 unique funds holding about $17 trillion in assets – managed to crush their passive rivals. Through June of last year (the last reported figures), 57% of all active funds managed to beat their benchmarks. Digging into various sub sectors, that number increases significantly.
Go Active With Your Investing!
When the EMH was created, the investment world was much different. In those 50+ years since, many of the items within EMH have changed. To that end, Thornburg suggests going active with their portfolios – and ETFs could be the way to do it.
One of the chief tenets of EMH has to do with transaction costs, and active ETFs are helping restore the balance and make active just as cheap as index funds. In fact, in some cases, investors can score active ETFs with cheaper expense ratios than passive ones. With such a low fee hurdle, active funds can exploit the issues with EMH and return those gains to investors.
Top-Performing Active ETFs
These funds were selected based on a 1-year total return, which ranges between 8.5% and 58%. They have expenses between 0.09% and 0.75% and assets under management between $6B and $30B. They are currently yielding between 0% and 9.4%.
| Ticker | Name | AUM | 1Y Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| ARKK | ARK Innovation ETF | $6.8B | 57.7% | 0% | 0.75% | ETF | Yes |
| DFUS | Dimensional U.S. Equity ETF | $6.6B | 24.4% | 1.37% | 0.09% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.9B | 19.5% | 1.43% | 0.17% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $6.65B | 19.1% | 1.6% | 0.25% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $7.8B | 16.5% | 1.4% | 0.28% | ETF | Yes |
| DFUV | Dimensional US Marketwide Value ETF | $8.2B | 11.2% | 1.91% | 0.22% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $29.1B | 8.5% | 9.33% | 0.35% | ETF | Yes |
In the end, the efficient market hypothesis was a great idea whose time has come. Ultimately, many changes to the world have potentially rendered it useless. To that end, active management and active ETFs could reign.
The Bottom Line
Passive investing has surged in popularity due to its exposure to the efficient market hypothesis. But several factors have made EMH obsolete in the modern world. To that end, active management and ETFs could help usher in a world of higher returns for portfolios.
1 Morningstar (June 2023). Morningstar’s U.S. Active/Passive Barometer Midyear 2023