Why active investing is good for the economy

Active money managers identify the most productive industries, invest in their stock, and signal to firms, through stock prices, where they should direct resources. Image: Shutterstock

In 2008, Warren Buffett famously challenged money managers at a hedge fund to prove that over a long period of time they would be able to beat the returns, after fees, of a passive fund that just mirrors the overall market. Buffett won the bet.

But Professor Simon Gervais of Duke University’s Fuqua School of Business, says there may be more to that result.  

“During those 10 years of the bet, the market went way up and hedge funds, which have reduced exposure to market movements, don't do well in bull markets,” Gervais said. “In fact, if you look at the end of 2010, Buffett was behind.”

In the working paper, Money Management and Real Investment, Gervais argues that active money managers provide a valuable contribution to the economy. Gervais believes they identify the most productive industries, invest in their stock, and signal to firms, through stock prices, where they should direct resources.

“As a result, the economy is going to be more productive and everybody benefits,” he said.

Gervais built a model that shows how the value of active managers’ wisdom about profitable companies is not just measured by the returns they deliver to their investors.

“We need to measure their contribution not just in returns, but also in utility terms,” Gervais said. “In economies with active money managers, stock prices better reflect the value of companies, firms make better real investment decisions, and the expected utility of all the investors in the economy goes up.”

Active vs Passive Funds

More than half of Americans own stocks, most of them through mutual funds. Active funds manage money on behalf of their investors, trying to outperform the average market returns. For this service, active money managers receive a fee. Passive funds place investors’ money in large samples of the market (for example the S&P 500 index) so that they reflect the average performance of the overall economy. Because they don’t hunt for the potentially best performing stocks, their management fees are lower.

Gervais said John Bogle of Vanguard created the first indexed passive fund in the late ‘70s. “Since then, the fraction of money invested in passive funds went from roughly 1% to almost 40%,” Gervais said. “In the last 10 years that number has nearly doubled.”

Gervais wanted to understand how the differences in passive and active investing impact the economy. The question is, he said, how good it would be for the economy if a larger portion of investors chose passive versus active investing.

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Impact of Active Managers

In Gervais’ model, the mere presence of active money managers may increase general economic prosperity, because of the information that they collect on what makes firms more valuable.

“Suppose that a company announces a merger,” Gervais said. “The company may think that the merger is going to create synergies. Skilled investors, like active managers, will look into that merger and may know something about how this will affect the landscape of that industry, how it will affect customers. So, they're going to react to that announcement and make investment decisions based on that information that the company itself may not know.“

Without active money managers, Gervais said, the signals that investors give to firms that need to decide where to put their resources wouldn’t be as precise.

“All investors benefit from an economy with money managers, potentially even those who, after fees, get a negative performance from active funds,” he said. “They would get a smaller share of a bigger pie.”

When Vanguard’s John Bogle was asked what would happen in an economy with only passive and index funds, his answer was “chaos, catastrophe.”

“And his reasoning was that for markets to operate efficiently, there has to be somebody who gathers the information that helps determine stock prices,” Gervais said.

For Gervais, there is no question that the growth of passive funds—and the participation of more people in the stock market—such as through retirement accounts—is a good thing.

For individuals, how they choose to participate in the market, should depend on wealth and risk aversion, he said.

“If my mom asked me how to invest her money—she is not rich and she's pretty risk averse—indexing is kind of what I would recommend,” Gervais said. “But if some of my students who are starting prosperous careers asked me, I would probably tell them to consider being at least partially active with their portfolio.”

[This article has been reproduced with permission from Duke University's Fuqua School of Business. This piece originally appeared on Duke Fuqua Insights]