One of the most common questions asset managers get is where they fall in the “active vs. passive” debate. It is a little bit of an oversimplification to frame the debate as a binary question when the reality is more nuanced. Both passive and active management are tools investors can use. Sometimes passive makes more sense and sometimes active is preferred.

The place for passive management

If you are an investor looking for general market exposure in the US, a widely available option is a standard S&P 500 index ETF. The cost of ownership is low and you know that you are getting the general market exposure.

More importantly, when you are talking about the mega-cap space, the winners and losers in the fight for market share have pretty much already been sorted out for most of the index. Performance should be tied to the overall economic environment and, in the long run, passive large-cap indices are designed to deliver market returns for an investor looking for that kind of exposure.

The place for active management

The history of innovation offers a counterexample. Almost everything we view today as a basic part of modern life was at one point a cutting-edge technology. Canned foods, trains, refrigeration, cars, plastics and PCs each dramatically changed our way of life and the way the economy operated at one time or another.

The companies involved in these innovative industries typically commanded high multiples of earnings relative to the broader market yet have gradually become part of the landscape. This process of cutting-edge innovation progressing into a staple of life has played out time and time again – it wouldn’t be a stretch to say that today’s most innovative businesses will likely be viewed the same way eventually.

In our opinion, active management really shines in segments of the market where the winners and losers have not been determined yet, in particular in rapidly growing industries. These nascent industries are popping up all the time and they are the fertile ground from which new and innovative businesses grow in our economic system.

When a nascent industry emerges, it usually results in hundreds of new companies vying to win market share. They compete and over time you usually have somewhere from three to five winners depending on the nature of the space. In time, this number will often be winnowed down to one or two as lesser winners are acquired by larger companies or merge to stay competitive. You hear about these winners because they often become household names and may eventually join the S&P 500 Index, but you rarely hear about the hundreds of new companies in nascent industries that fail.

It is an active manager’s job to understand a nascent industry, to work with experts in the field, and to identify which companies are believed legitimate contenders to take market share as well as which companies are pretenders being swept along in the growth of a nascent industry. Winners may deliver extraordinary returns to investors over time and losers will often go bankrupt. Unlike in established industries, it is a situation where diversification kills. Investors want to have exposure to the winners and avoid the losers at all costs. The broad brush of passive indices does not work here. In our opinion, only active management can realize the potential in these industries.

Active management in this space has become especially important over the past 20 years as the private equity market has grown and evolved. Historically, conventional wisdom said that small and mid-cap indexes included companies that were growing and innovating. Companies would IPO small and bubble up to the larger ranks, but that really isn’t the case anymore. Private equity in Silicon Valley has changed when the most dynamic and innovative companies IPO. When Intel issued its IPO in 1971, the total value was $8.2 million. Adjusting for inflation that would be about $53 million in today’s dollars. Cisco’s IPO in 1990 was based on a market cap of $224 million or $443 million in today’s dollars.

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