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Who's Smarter: Active or Passive Investors?

There are numerous studies out there on why passive investors typically do better than active investors over the long term. But the author of a recent study suggested that the outperformance may be due to investor sophistication.

Mutual fund investors demonstrate their decisions based on fund flows. And while passively managed funds have been steadily gaining share for the past few decades, the active world still dominates in terms of market share. Since the overwhelming body of evidence demonstrates both that active funds underperform passive funds by wide margins and that there's no persistence in performance beyond the randomly expected, we might conclude that, in aggregate, passive investors are "smart money" and active investors are "dumb money." However, that alone isn't sufficient evidence. The reason is that investors also demonstrate their preferences through asset allocation decisions -- how they invest across funds. In other words, do their asset allocation decisions increase or decrease future wealth?

To determine whether active or passive investors make more intelligent asset allocations decisions, David Blanchett used a survivorship bias-free a database of mutual funds using data from Morningstar. To be included, a mutual fund needed to have a Morningstar category in one of the nine domestic equity styles for at least one month from January 1993 to June 2009.

In his study "Do Passive or Active Investors Make Better Asset Allocation Decisions?," Blanchett found that while actively managed domestic equity styles that receive larger inflows are likely to outperform their peers on a short-term basis (three to six months) due to the momentum effect, they underperform on a long-term basis (three years). On the other hand, passively managed domestic equity style funds that receive large inflows are likely to outperform both on a short-term and long-term basis. This suggests that both types of investors are smart in the short term, while active investors are dumb and index investors are smart in the long term.

Blanchett suggested that these findings may be caused by index investors being more sophisticated (i.e., more intelligent) and less swayed by short-term investment trends than active investors.

Here's my explanation. Simply put, while passive investors acknowledge that it's possible to beat the market, they know the odds of doing so are so low it's not prudent to try. And they're able to "check their egos at the door" and accept market returns. They know that by earning market returns, in aggregate, they'll earn above average returns after costs. That can certainly be interpreted as a sign of sophistication.

Blanchard concluded that whatever the explanation, by all appearances, in aggregate, passive investors seem smarter not only because they pay less for their beta exposures (through lower management fees), but also because they make better asset allocation decisions.

More on MoneyWatch:
Are You Dumb Money? Asset Allocation Is Not Dead Do I Need More Than One Advisor? Goldman Vs. Morgan: Who to Believe? Why Index Funds Only Receive Three Stars from Morningstar
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