Why active bond investors can beat the index when active equity investors can’t

IMAGINE A WORLD in which the stockmarket has only two constituents: Gurgle, a firm that has risen quickly, and Genial Motors, a mature company. Both have 100m of shares outstanding, each worth $1. That gives the market a value of $200m. Further imagine that there are two investors of equal size in the market. Both own the same no-cost index fund. Each has wealth of $100m, split between Gurgle and Genial stock.

After a year Gurgle triples in value to $3 a share, while Genial stays at $1. The market has doubled to $400m. Three-quarters of its value is in Gurgle stock. Both investors still hold 50m shares of each firm. Their total holdings are now worth $200m each: $150m-worth of Gurgle; $50m of Genial. They have shared in the market’s surge. This is a quality of passive investment in an index weighted by value. If some stocks soar in price, you share proportionately in their success.

But say our investors were active rather than passive, with one holding 100m shares of Gurgle and the other 100m of Genial. The Gurgle investor triples his wealth; the Genial investor’s wealth is unchanged. Simple maths mean that if one active investor beats the index, another must be beaten by it. And since active equity managers have higher fees than passive ones, active investing is on average a losing game in real life. Few beat the index...

via The Economist: Finance and economics Business Feeds

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