Hi Jason,

Thanks for your detailed, thoughtful and indeed thought provoking reply. Your reply is worthy of being an article in its own right, questioning some of the ideas behind passive strategies.

I myself am an active investor and so I appreciate the debate over whether there can be any sustainable outperformance over the long run. Clearly I believe it is possible though I also think that passive indexed strategies can lay a solid foundation for a portfolio. I just want to respond on a few points:

I do acknowledge that passive strategies are not frictionless, involving management fees and trading commissions [and taxes], though in a buy and hold strategy, both are modest. I do believe that active managers really need to “earn” their salaries and be symmetrically rewarded or punished relative to their performance to their benchmarks. Otherwise they are not adding value and indeed are subtracting value.

Your point about what is The Market is a crucial one. As you have pointed out, the market as a whole is not an investable benchmark since it includes all sorts of assets including art, wine, or for that matter farmland and other hard assets that are not properly replicated in the form of an investable index. Perhaps the financial engineers may be able to find a way to do it though this might end up being a net negative event rather than a positive one.

I too am perplexed by the use of tracking error as a performance criteria for active money managers. It is almost schizophrenic for investors to want outperformance and yet at the same time want a close adherence to benchmark performance. It is a contradiction. I find it hard to understand why they don’t just in this case go to an index fund.

As for logical premises, you are right, they need to be tested to reveal misunderstandings over premises and assumptions. Rational and efficient markets are not always the case, at least in the short term. In the long run, it seems to me that investors must believe that the market eventually “gets it right”, since otherwise it will make no sense to invest at all since it becomes a game of chance.

Thanks, Jamie