One of the most controversial subjects in the financial services industry is the issue surrounding the value of active investment management (AIM) in the secondary capital markets. The value of AIM has been debated by many investment professionals for more than a decade. While the results of the studies are mixed, a strong case has been made that investors should replace their actively managed investment products with products that rely on passive investment management (PIM) strategies. Let's take a look at the difference between AIM and PIM and see which type of investment strategy is most likely to offer you the opportunity to generate the highest risk-adjusted performance over time.
Active Vs. Passive Investment Management
AIM is an investment process that is used by investment professionals in order to assist them in making profitable investment decisions. AIM requires the use of time, resources, labor, knowledge and experience in order to assess the attractiveness of a company from an investment standpoint. Investors utilize AIM in order to select securities for addition to their portfolio, and to assist them in determining the appropriate weighting that each security should represent within their portfolio. In comparison, investors that utilize PIM strategies concentrate on the replication of the performance of a given benchmark proxy, such as the S&P 500 Index. The distinction between these two methodologies is significant, as PIM strategies ignore most of the traits that are typically believed to encompass high-quality investment analysis.
Given the differences between the two methodologies, a prudent investor may expect strategies based on AIM to outperform strategies based on PIM, especially over time. Ironically, most of the empirical evidence makes a strong case to the contrary. Given this conundrum, one must wonder how a passively managed investment product, such as an S&P 500 Index fund, is able to outperform a robust investment product that utilizes a prudent investment strategy such as AIM.
A partial answer to this question lies in the fact that PIM strategies require minimal resources to employ, and therefore have a significant structural advantage over higher cost investment options that utilize AIM. While this argument may be plausible, a significant case can also be made that the superiority of PIM strategies is attributed to the possibility that the secondary capital markets are informationally efficient, and therefore AIM strategies cannot add value when applied in this type of environment.
Capital Market Efficiency and the Secondary Capital Markets
When investors talk about efficient capital markets, they mean that the securities that trade in the markets have prices that accurately reflect all material information about their value in a real-time manner. Market efficiency does not mandate that stock prices will always reflect the correct per share value of a company. However, it does mean that security prices are accurately priced, and that any fluctuation in that price is unpredictable in terms of timing, frequency, magnitude and direction because the flow of information is unpredictable.
Factors That Mitigate the Value of Active Investment Management in the Secondary Capital Markets
There are four primary factors that promote market efficiency in the secondary capital markets.
- The mission of the secondary capital markets
- The prohibited use of material non-public information
- The mandates set forth by Regulation Fair Disclosure (Reg FD)
- The increase in passively managed assets under management
Second, for an AIM strategy to reliably add value in the secondary capital markets, the use of the strategy would have to uncover important information about a company that is currently not reflected in the price of the company's security. However, this type of information is typically known as material non-public information, and it is illegal for investors to buy or sell securities based on their access to this type of privileged information. A classic example of the prohibited use of material non-public information is the high profile insider trading violations that are routinely covered by the general media.
Third, in October 2000, the Securities and Exchange Commission implemented Reg FD. Reg FD mandates that material information about a company be disseminated in a timely manner to a wide audience of investors. It helps mandate transparency, and helps promote strong ethical standards in the secondary capital markets. However, it also hinders the ability of AIM to add value, because it minimizes the amount of time that investment professionals can capitalize on their knowledge of material public information. Moreover, Reg FD particularly hinders investors who want to make multiple purchases of a security over time, such as those that employ a dollar cost averaging strategy.
Finally, PIM strategies have gained significant popularity over the last decade, and many experts believe going forward there will be a greater shift to passively managed funds. Therefore, as a greater percentage of assets under management become passively managed, it will become more difficult for AIM strategies to add value, because more and more of the assets invested in the secondary capital markets will be invested according to PIM strategies, which largely ignore the factors that AIM strategies take into account when assessing the value of a security issued by a company.
The Bottom Line
In today's global economy, it is hard to fathom that a single investor, or even a large investment research team, will have enough time, knowledge, resources and skill to correctly foresee and assess all of the macro economic issues, micro economic issues, governmental issues, technological changes, legal issues and unique business risks in order to correctly determine the value of a company. Moreover, even if all of these issues can be accurately assessed, there is no way for an investor to gauge how other investors will assess all of this information, or how their assessment will affect their investment decision. Therefore, without this level of insight, it is impossible to know how the price of a security will change, the frequency with which its price will change, the magnitude of its price change, or the direction in which its price will change.
Given this level of unpredictability, one must consider the possibility that the secondary capital markets are indeed efficient, and that the employment of AIM in the secondary capital markets may very well be a noble, but futile endeavor.
More From Investopedia