For a change, let us not talk numbers and approach investing through concepts first.
Let us begin with passive investing and work our way towards the active mode.
Passive investing is a strategy focused on making minimal transactions in a portfolio and staying put for as long as possible. The most popular passive strategy is index investing. It is about investing in a benchmark representative index and holding it for the long term. NIFTY 50 and SENSEX are popular representative indices.
When a market reaches the highest degree of efficiency, it means that all information pertaining to share prices have been factored into the prices. When all information is factored into prices, there remains no concept of overvaluation or undervaluation.
This brings us to Fama’s Efficient Market Hypothesis, which asserts that in an efficient market all anomalies will be arbitraged almost immediately. This translates to the fact that given a zero-anomaly or efficient market, investors cannot outperform the market in the long run.
As the quantity and quality of information improves, the quantum of investing opportunities opening because of the mispricing will go down.
Now, the set of investors who agree to this, turn to index investing. Obviously, they also need to agree to the fact that the market they operate in is a highly efficient market.
While the degree of efficiency continues to be a topic of hot debate among investment professionals around the world, I would like to make peace with the believers (for the moment) and accept that markets are indeed efficient. This also means that collective wisdom (indices) will outperform individual attempts (actively managed portfolios).
Side note: Here’s a quick update on current affairs: As of March 2020, global assets in passive products are reported to have breached the $5 trillion mark, with a product suite of over 7,000. Passive products in the US account for ~70 per cent market share. Following suit, India reflects increasing belief in the concept of index investing – we can thank the principle of weighted average for a stellar performance by representative indices and incremental retail participation.
Now that we have a critical mass of believers, a couple of cheerleaders and a handful of influencer endorsements in favour of index investing, let us continue to extrapolate.
Soon, as the proportion of index investors increase, demand-supply economics will dictate an uptick in the broader index. Now, because of the way indices are constructed, index-buying will result in money being distributed among the constituents on the basis of market-capitalisation weights – the shares with larger market capitalisation will receive a larger proportion of the invested money.
Capital is spread across the constituents in a beautifully uniform manner, leading to an almost uniform price increase across the board. Hold onto this thought.
Price moves dictated by perceptions
Share prices are driven by expectations, while companies are run on real metrics such as earnings and profitability. Fair valuation is when the perception aligns with real performance.
Here’s the turning point.
Companies represented on the index will not perform as uniformly as the capital being allocated to their shares on the index. Business environments will not remain uniform. Market dynamics will not remain uniform.
Here is where valuations begin to distort and mispricing of shares begins.
Enter active fund management, an investing style focused on identifying the mispriced shares, opportunities presented by dynamic business environments and value yet to be unearthed by market evolution.
Did we just come a full circle?
Perhaps active investing will thrive on the success of passive investing. At the same time, there is nothing to rule out that the two will thrive symbiotically. Only time can unravel the future.(The writer is Head-Research, fisdom. Views are personal)