We have happened upon that time in the investment cycle when investors vastly eschew active management of their assets in favor of a more passive management style. In fact, I read recently 461 Hedge Funds, a hallmark of active investment management, shut their doors in the first half of this year alone. If liquidations continue at that rate, they'll outpace the 1,023-closure record from 2009. All signs now indicate that active management has fallen out of vogue.
And why wouldn't it? Index funds have done very well these past few years; whereas active managers have underperformed the major averages. The problem is when everyone piles into or out of the same investment philosophy, it usually signals it's time to change course. Therefore, I predict the tides will soon change and active management will make a huge comeback.
Passive investing, such as Index mutual funds, is an easily understood investing style that allows you to access broad segments of the market. Indexing has been called investing on autopilot. This is a strategy that tends to work well, until it doesn't. Take the mid to late 90's, when it appeared the stock market would always go up. Everyone from your hairdresser to the cab driver was a stock genius. New websites such as the Motley Fool preached that you didn't need an investment advisor–just buy a broad basket of stocks (especially in the technology sector) and you would get rich. And, if got out before March 10, 2000, you were all set.
However, if you failed to get out then, we all know what happened–your portfolio quickly crashed and caused the loss of $5 trillion in the market value of companies from March 2000 to October 2002. During this time, only managers who offered a long/short and dynamic asset allocation strategy produced positive returns.
Another feature of the passive investment approach argues that you don't have to actively manage your investments as long as you stay diversified. This is referred to as the Modern Portfolio Theory (MPT). MPT is a mathematical formulation that creates diversification in investing, with the aim of selecting an assortment of investment assets that have a collectively lower risk than any individual asset. This is possible, so the theory goes, because different types of assets often change in value in opposite ways. For example, the stock market often moves in the different direction from yields in the bond market. Therefore, a pool of both types of assets can nearly always (in theory) offer lower overall risk than holding just one asset class exclusively.
