Active versus Passive: Old Wine in New Wine Skins

Abstract

Creators of 1970s’ capital asset pricing model could not have imagined how their descriptive theory of risk and return would come to dominate as a normative benchmark and reach extreme cycles of concentration. The cap-weighted index is central to the topic of active versus passive equity management. The authors study the 30-year history of S&P concentration cycles (when, on a few occasions, a handful of stocks dominates the metric). Excessive, policy-induced monetary expansion (M2) plus long-term bond rates predict index concentration and explain the return spreads between the S&P 500 index and alternatives (portfolio-weighting schemes or manager skill). The periodic comparisons between active skill investing and passive indexing have more to do with index concentration behavior and less to do with skill variability. As of 2020, a shift toward a new 10-year period of dominance for active and alternative strategies appears to have emerged. The authors expect stock selection and thoughtful risk management to retake their prominence as key drivers of success in global equity markets.