A paper co-authored by Michael Mauboussin of Credit Suisse addresses important issues to consider in relation to the continued and increasing shift from active toward passive fund management.

Those investors who are moving their money to passive funds, the paper argues, are “less informed than those who stay.” For every winner, it says, there must be a loser—and if there are fewer losers, the game becomes less interesting. In other words, as markets become more efficient (fewer losers) the potential upside for the winners (passive funds) is reduced. While associated with lower costs, passive fund management also “introduces the possibility of market distortions, including crowding and illiquidity.”

Mauboussin and his team argues, “Research shows that fundamental money managers who take a long view and are truly active can deliver excess returns. It is essential to identify a repeatable source of edge and to align the investment process to capture that edge.”

The paper offers the following recommendations for investors:

• Index investing might be a better fit for those lacking the “time or sophistication to evaluate investment managers;”
• Dispersion is key. “Research shows that there is more opportunity for excess returns in asset classes where the dispersion of returns for asset managers is wide;”
• Do your homework. Careful examination of active managers–including past performance, industry experience and economic conditions under which they excel—can lead to “better probability of identifying skillful active managers.”

In conclusion, the paper asserts, “The debate over active versus passive investing can take tones of religious fervor.” However, it argues that such a strong consensus warrants investor caution.  “Not only can active and passive co-exist, they must.”