The tussle between active and passive management has been going the passive way in recent years, if recent headlines are a reliable guide. Some are starting to wonder at what point the success of passive management would start to undermine its own foundations.
How much passive management is too much?
Passive management, after all, mimics the collective actions of the rest of the market1 and the portfolio a passive manager holds is only as good as the combined wisdom of the active manager community. Passive management implicitly assumes that market prices fairly reflect all available information, but the only way that can happen is if active managers trade on new information until it’s fully priced in.
So, as the proportion of the U.S. stock market that is passively managed increases, it’s natural to wonder at what point passive management gets too big. That’s a question that Barry Ritholtz has posed to a number of high profile names as part of his podcast series on Bloomberg View. Although there was a pretty wide range of answers, some went high: Burton Malkiel (whose 1973 book A Random Walk Down Wall Street played a significant role in the development of passive management), for example, felt that “when indexing is 95% of the total, I might start to worry about that.”
But I suspect that the composition of the active manager community is more important than the amount of active management. After all, a large number of active managers following genuinely diverse strategies seems like a better formula for arriving at a good collective answer than a handful of giants, especially if those giants are all similar to one another, hire similar people and follow similar approaches.
In his 2004 work The Wisdom of Crowds, James Surowiecki argued that collective judgment is at its best when three conditions apply: diversity, independence and a particular kind of decentralization (by which he means an effective means of aggregating views.) The third condition is pretty well taken care of by the market mechanism (as I argued here).
So, when thinking about the price discovery role of active managers, we need to look at how diverse the manager community is, not just at how big it is. That is itself a complex and evolving question, with the effects of globalization, consolidation and innovation all at play. Indeed, while many people have given thought to the “how big is too big?” question, I’ve not come across much discussion of the composition of the active manager community. So I plan to return to that in a future post – and would welcome any thoughts that readers may have on that topic.
1A portfolio that is passively managed against a non–cap–weighted benchmark is, for the purposes of this post, just an active portfolio with a simple investment process.