Why Active Investing Is a Negative Sum Game
William F. Sharpe has a great article in the January/February 1991 issue of The Financial Analysts Journal (Vol. 47, No.1, pages 7-9). The title is “The Arithmetic of Active Management.” It should be required reading for academics and investment professionals alike. The paper makes a simple point that we call equilibrium accounting. Consider the portfolio of U.S. common stocks with each stock weighted according to its market capitalization. There is another way to define this cap-weight market portfolio. It is the portfolio that combines the U.S. equity portfolios of investors, with each investor’s portfolio of U.S. equities weighted by that investor’s share of the total market cap of U.S. equities.
Active vs. Passive Management
Let us agree on what we are debating, discussing and disagreeing about: active vs. passive management. Active management is the art of stock picking and market timing. Passive management refers to a buy-and-hold approach to money management. It can be applied to any asset class: big stocks, small stocks, value or growth, foreign or domestic can all be accessed by passive techniques. Neither label, “active” or “passive,” is perfect, and there will not always be a complete dichotomy between them.