Traditionally, the dichotomy of investment models consists of active investing and passive investing, also known as indexing. To these two, financial researchers are striving to add a new category, which is commonly referred to as evidence-based investing.
In the active investment sector, brokers and fund managers try to outperform the reported performances of indexes (simply, ‘to beat the market’) with financial placements that will generate a return higher than others did in the past. Consequently, active investing is uncertain, since it is based on personal predictions concerning the evolution of the demand and supply on the market, and thus subject to a higher risk of default.
On the other side, passive investment is safer since it follows the trodden path of stock transactions (indexes). Fund managers declare that they will seek to benchmark the fund (simply, to make placements that fit within the reported limits of the indexes), or some misleadingly declare that they will engage in active investing, without actually doing so, merely clinging to an index (a practice that is also called closet indexing, see BETTER FINANCE’s project here). This means that the investments’ evolution in time either (i) coincides with the index or either (ii) reports a very small, insignificant out- or under-performance of the given index.
This model has a far lower risk profile and generates lower, but more certain returns on investment, thus being used in sectors such as pension funds. At the same time, management fees, charges and costs for the investor are far lower, rendering higher returns (and more capital to invest). Over the long-term, passive management has been shown to outperform active management, partly because the high fees of active management (due to the risk profile) eat into the returns of the investors.
Example of Active Investment
Example of Passive Investment
As for evidence-based investing, researchers do not necessarily equate it to passive investing, but it shows many similarities to it. Evidence-based investing is, according to Sam Instone of Aes International, a model that uses thorough, independent, and peer-reviewed academic research as a basis for the investment plan. In other words, this model opts to abide to the demonstrated trends in financial markets and back their placements on data, reducing the error risk. As Russ Thornton of Seeking Alpha describes it, this model’s backbone is ‘evidence in the form of rigorous academic research performed over long periods of time’, which he deems more secure than ‘relying on hope which is the underlying investment philosophy of many financial advisors as they attempt (and often fail) to outperform the market’.
In this sense, one interview could (and should) catch an investor’s attention: Sam Instone’s Secrets of a Self-Interested Industry Laid Bare: An Enlightening Interview with the Evidence-Based Investor. The interview focuses on Robin Powell’s experience and advice concerning evidence-based investing and why this model actually focuses on the investor’s interests rather than those of the broker or of the fund manager.
Robin Powell explains how he learned about evidence-based investing and why it is a much more certain way of generating income, as opposed to active investing. He notes that financial traders form ‘a hugely powerful and lucrative industry [...] acting in its own interests to the detriment of hundreds of millions of investors around the world’, where active investing is underlined by the ‘inconvenient truth’ that ‘beating the market is extremely hard to do net of fees over the long-term’.
One of the ‘secrets’ he shared with the interviewer is that ‘investing works in completely the opposite way to most other goods and services’. Thus, the more you pay in fees (such as management fees, risk fees etc.) for investments, the less money the investor will be prone to get back.
The reason why evidence-based investing is not always equated to passive investing is that the latter relies on a reported past-performance of a chosen benchmark (S&P 500, Dow Jones, MSCI etc.), where the first is backed by fundamental academic research, involving much more data and analyses, which is also subject to peer-reviews. This way, the predictability of an investment’s return over a determined period of time, so claim its fierce supporters, is higher for evidence-based investing than passive investing.
In the end, one could argue that the essence of an investment portfolio is its degree of certainty in terms of profit generation. In cases where the probability of profit is thoroughly proven to be higher, the profit (and management fees) is likely to be lower, but more certain. The proportionality between return-ratio and the degree of certainty is materialized in the risk profile of the investment project.
Active supporters of evidence-based investing claim that, statistically, those who opt for this model over the active investment model have much higher returns. On the other side, traditional brokers or fund managers claim that the theory is ridiculous and that it does not reflect the reality of the financial markets.
The purpose of the interview, and of this article as well, is to send the message that evidence-based investing (or, an investment model between passive investment and evidence-based investment) is the safest and most profitable choice for making money out of money over longer periods of time.
Read more about evidence-based investing, passive investing and active investing and the difference between these here and here.