Closing Bell: Passive or active? The answer is both are in need of each other

Last month saw a historic milestone in the investment world. The giant fund manager Fidelity, which is to flogging investments what Tesco is to selling groceries, was knocked off its perch as the biggest US manager of mutual funds by a company called Vanguard.

The real significance of this is that the two firms represent very different ways of managing money, based on radically opposed investment philosophies.

Fidelity is a champion of "active" investment, which claims that talented and experienced individuals can, over the longer term, beat the market by owning a shortlist of investments actively chosen and managed in line with certain criteria. The skills required to perform this task consistently well are rare and valuable, and as a result top fund managers are very well paid. Not coincidentally, active funds charge high fees.

In contrast, Vanguard is the most successful exponent of so-called "passive" investment, where the aim is not to beat the market but to track its performance as closely as possible. They save a huge amount of money by not having to employ platoons of millionaires, and their fees are correspondingly lower.

The insight on which Vanguard was built was most eloquently formulated in 1963 by Burton Malkiel in his brilliant book A Random Walk Down Wall Street.

Theory suggests, and observation apparently confirms, that it is so hard to beat the market consistently over the long term, without taking significant risks, that the number of managers who have done so is vanishingly small; so small, in fact, that investors have virtually no chance of identifying these geniuses in advance.

Holders of this view, often called the efficient markets hypothesis (EMH), agree with fundamental stock-pickers that the crucial determinant of share prices over the long term is company profits; they claim, however, that forecasting these profits accurately, let alone the appropriate valuation for them, is effectively impossible. EMH in its various forms is pretty much the prevailing orthodoxy among economists who analyse financial markets and, as the success of Vanguard indicates, it is gaining increasing support from investors.

EMH is highly persuasive, so why do so many people resist it? Some of the resistance is self-interest or self-deception, but at the heart of it is an unformulated awareness of how far an outwardly simple hypothesis is in fact deeply paradoxical.

EMH claims in effect that investment offers no systematic premium to superior effort or intelligence. This is unusual if not unique among conscious human activities. If throwing darts at the Wall Street Journal is no better or worse a method of picking stocks than thorough research by highly experienced and intelligent specialists, it follows that we have no fully objective and rational way of telling what an appropriate value for a share is. As Malkiel put it: "Even God Almighty does not know the proper price-earnings multiple for a common stock."

But the effort is as practically necessary as it is theoretically impossible.

The secondary market for shares - trading in the stock market - usually overshadows the primary market, in which investors are asked to put equity finance into some new venture; here even the most radical proponents of EMH would hesitate to claim that when valuing such companies you might as well pick a number at random.

Prices reflect the current scope of the enterprise, its background, structure and prospects, and the valuations of similar enterprises. In this pragmatic approach there is a lot more art than science - rather like buying a house - but most of the time it seems to work reasonably well. Markets are price-setting mechanisms; but markets are composed of competitive individuals who have differing opinions.

Markets could not be efficient unless investors tried to beat them.

This is the paradox at the heart of EMH; prices can only be an efficient reflection of investors' best guesses if investors are actually competing to make those best guesses.

Passive investment is theoretically solid and commercially attractive, but it is inherently self-limiting - if the whole market were passive, apparent pricing anomalies would soon arise which investors would try to exploit.

So the resolution is clear. Active markets need passive funds, which keep active investors honest by setting a tough target to beat. But passive funds depend upon markets which can only function properly as a meeting place for talented and competitive individuals trying to outdo each other. For what ambitious person, on the threshold of a career, sets out with a burning desire to be average?

l Gareth Howlett is fund manager director at Brooks Macdonald Asset Management.