One of the most controversial subjects in the financial services industry is the issue surrounding the value of active investment management (AIM) in the secondary capital markets. The value of AIM has been debated by many investment professionals for more than a decade. While the results of the studies are mixed, a strong case has been made that investors should replace their actively managed investment products with products that rely on passive investment management (PIM) strategies. Let's take a look at the difference between AIM and PIM and see which type of investment strategy is most likely to offer you the opportunity to generate the highest risk-adjusted performance over time.

Active Vs. Passive Investment Management
AIM is an investment process that is used by investment professionals in order to assist them in making profitable investment decisions. AIM requires the use of time, resources, labor, knowledge and experience in order to assess the attractiveness of a company from an investment standpoint. Investors utilize AIM in order to select securities for addition to their portfolio, and to assist them in determining the appropriate weighting that each security should represent within their portfolio. In comparison, investors that utilize PIM strategies concentrate on the replication of the performance of a given benchmark proxy, such as the S&P 500 Index. The distinction between these two methodologies is significant, as PIM strategies ignore most of the traits that are typically believed to encompass high-quality investment analysis.

Given the differences between the two methodologies, a prudent investor may expect strategies based on AIM to outperform strategies based on PIM, especially over time. Ironically, most of the empirical evidence makes a strong case to the contrary. Given this conundrum, one must wonder how a passively managed investment product, such as an S&P 500 Index fund, is able to outperform a robust investment product that utilizes a prudent investment strategy such as AIM.

A partial answer to this question lies in the fact that PIM strategies require minimal resources to employ, and therefore have a significant structural advantage over higher cost investment options that utilize AIM. While this argument may be plausible, a significant case can also be made that the superiority of PIM strategies is attributed to the possibility that the secondary capital markets are informationally efficient, and therefore AIM strategies cannot add value when applied in this type of environment.

Capital Market Efficiency and the Secondary Capital Markets
When investors talk about efficient capital markets, they mean that the securities that trade in the markets have prices that accurately reflect all material information about their value in a real-time manner. Market efficiency does not mandate that stock prices will always reflect the correct per share value of a company. However, it does mean that security prices are accurately priced, and that any fluctuation in that price is unpredictable in terms of timing, frequency, magnitude and direction because the flow of information is unpredictable.

Factors That Mitigate the Value of Active Investment Management in the Secondary Capital Markets
There are four primary factors that promote market efficiency in the secondary capital markets.

  • The mission of the secondary capital markets
  • The prohibited use of material non-public information
  • The mandates set forth by Regulation Fair Disclosure (Reg FD)
  • The increase in passively managed assets under management

To begin, the goals of the secondary capital markets are to provide liquidity and transparency of trade completion. Given these goals, the mission of the secondary capital markets mandates that security prices are accurately priced. To explain, the secondary capital markets were created to allow companies to maintain long-term access to capital that they received through an initial public offering, while allowing investors that supplied the capital to have a market that will allow them to exit out of their investment in a timely manner with minimal price impact. Given this mission, it stands to reason that the secondary capital markets must maintain a level of efficiency in order to maintain investor confidence in the system. If this trust breaks down, the secondary capital markets will lose credibility and ultimately cease to function in a beneficial manner for both the management of the companies needing capital, and the investors that are willing to provide capital.

Second, for an AIM strategy to reliably add value in the secondary capital markets, the use of the strategy would have to uncover important information about a company that is currently not reflected in the price of the company's security. However, this type of information is typically known as material non-public information, and it is illegal for investors to buy or sell securities based on their access to this type of privileged information. A classic example of the prohibited use of material non-public information is the high profile insider trading violations that are routinely covered by the general media.

Third, in October 2000, the Securities and Exchange Commission implemented Reg FD. Reg FD mandates that material information about a company be disseminated in a timely manner to a wide audience of investors. It helps mandate transparency, and helps promote strong ethical standards in the secondary capital markets. However, it also hinders the ability of AIM to add value, because it minimizes the amount of time that investment professionals can capitalize on their knowledge of material public information. Moreover, Reg FD particularly hinders investors who want to make multiple purchases of a security over time, such as those that employ a dollar cost averaging strategy.

Finally, PIM strategies have gained significant popularity over the last decade, and many experts believe going forward there will be a greater shift to passively managed funds. Therefore, as a greater percentage of assets under management become passively managed, it will become more difficult for AIM strategies to add value, because more and more of the assets invested in the secondary capital markets will be invested according to PIM strategies, which largely ignore the factors that AIM strategies take into account when assessing the value of a security issued by a company.

The Bottom Line
In today's global economy, it is hard to fathom that a single investor, or even a large investment research team, will have enough time, knowledge, resources and skill to correctly foresee and assess all of the macro economic issues, micro economic issues, governmental issues, technological changes, legal issues and unique business risks in order to correctly determine the value of a company. Moreover, even if all of these issues can be accurately assessed, there is no way for an investor to gauge how other investors will assess all of this information, or how their assessment will affect their investment decision. Therefore, without this level of insight, it is impossible to know how the price of a security will change, the frequency with which its price will change, the magnitude of its price change, or the direction in which its price will change.

Given this level of unpredictability, one must consider the possibility that the secondary capital markets are indeed efficient, and that the employment of AIM in the secondary capital markets may very well be a noble, but futile endeavor.

Related Articles
  1. Investing Basics

    Why Companies Stay Private

    Many private companies prefer to stay private and find alternate sources of capital. Find out what firms have to gain by eschewing the windfall from a flashy IPO.
  2. Mutual Funds & ETFs

    Benchmark Your Returns With Indexes

    If your portfolio is always falling short, you may not be making an apples-to-apples comparison.
  3. Economics

    The SEC: A Brief History Of Regulation

    The SEC has continued to make the market a safer place and to learn from and adapt to new scandals and crises.
  4. Investing Basics

    IPO Lock-Ups Stop Insider Selling

    Ownership plays a key role when companies go public. Find out how.
  5. Mutual Funds & ETFs

    Active Share Measures Active Management

    A 2006 study proves the effectiveness of a new way of sizing up your portfolio manager.
  6. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  7. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  8. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  9. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  10. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  1. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  2. When are mutual funds considered a bad investment?

    Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
  3. What fees do financial advisors charge?

    Financial advisors who operate as fee-only planners charge a percentage, usually 1 to 2%, of a client's net assets. For a ... Read Full Answer >>
  4. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  5. How often do mutual funds report their holdings?

    The Securities and Exchange Commission (SEC) requires mutual funds to report complete lists of their holdings on a quarterly ... Read Full Answer >>
  6. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!