How to invest can sometimes be more important than where to invest. That is why looking at the rationale to invest in active or passive strategies is highly relevant
The ability of managers to over-perform the market is the source of much debate in the Financial Economics discipline because of the underlying debate on the validity of the Efficient Market Hypothesis. The consensus is that the degree of over-performance a manager can achieve is related to the level of inefficiencies in the market it operates in. Illiquid assets are usually associated with higher inefficiencies, as shown by the higher dispersion of returns on Venture Capital, LBOs and Real Estate (basically Private Equity), because of the higher valuation uncertainty.
Furthermore, in Private Equity there is a big set of evidence showing that fund managers that outperform the market consistently do so over successive funds: it is not only the volatility of returns that drives the differences, it is the difference in skills among managers.
Therefore, good fund managers can greatly outperform the market in these asset classes, making a solid case for active investments through funds.
Publicly traded asset classes such as stocks and bonds show more concentrated returns across asset managers with lower after-fees persistence in returns. The main driver in these markets is the return of the benchmark. Consequently, good asset managers perform similarly to bad ones and they usually barely justify the fees spent on them.
Private Equity assets are also the ones where it is harder to diversify a portfolio of direct investments passively since minimum tickets are usually sizeable, there are no direct investment diversified vehicles and the costs of analyzing and selecting deals is very high.
Publicly traded markets provide easier ways to have a diversified exposure to a whole array of individual assets across an asset class through ETFs or directly investing in the individual assets. Consequently, investing in active funds does not provide diversification advantages over passive funds.
Publicly traded markets provide easier ways to have a diversified exposure to a whole array of individual assets across an asset class through ETFs or directly investing in the individual assets. Consequently, investing in active funds does not provide diversification advantages over passive funds.
I avoided talking about Hedge Funds on purpose because their case is more difficult. On average, Hedge Funds exploit the inefficiencies of liquid markets, but they amplify these differences by deviating from benchmarks, using leverage, beta neutral strategies and many other non-conventional tools. There is no passive way to do a Hedge Fund, so there is no way to avoid them and get exposure to their strategies. Risk-adjusted returns analysis for HF is very hard to perform since they use non-linear trading strategies; but most evidence is consistent with pointing out that they do not outperform the market on a risk-adjusted basis. So, the decision here is not whether one should get active or passive exposure to HFs strategies, but whether one should invest in HF strategies at all. A debate for a different entry. However, I do believe that HFs are a more sensible way to search for alpha in public markets than regular mutual funds since they have enough discretion to do so.
Conclusion
To sum up,on average, it is better to invest with active managers in illiiquid, inefficient and volatile markets (Private Equity, Frontier Markets Equities, Frontier Markets Debt, Emerging Markets High Yield. etc) and to invest passively in liquid, efficient and stable markets (Large Cap, US Treasuries).
