The funny thing about passive investing is that there's an intuitive argument that it shouldn't work and an equally intuitive argument that it has to (and the second one is right). The simplest anti-passive argument, and the one that was so common it delayed the widespread use of passive investing by decades, was that choosing a more or less random assortment of stocks, without regard to their valuation, growth prospects, news flow, etc. couldn't possibly be a better idea than carefully analyzing businesses in order to find the cheap and/or good ones, and buying those. The counterargument goes like this: by definition, investors in the aggregate have 100% net long exposure to the stock market. For anyone to outperform, someone else has to underperform, and performance is net of fees and taxes. Or, as Munger likes to say, “the iron rule of life is that only 20% of people can be in the top fifth.” Thus, for the average investor, it's a much better deal to just get broad market exposure than to try to choose individual stocks.

And this is, broadly speaking, true. But it's an incomplete story. "The market" is doing a lot of work here. Consider an economy that has two operating companies and one savvy private equity firm. The two companies' market values fluctuate from time to time, and when one of them gets cheap, the PE firm takes it private. Once it's expensive again, the PE firm sells it. If "the market" is defined as the set of all public companies, then buying the entire market means generally taking the other side of a trade with an investor who gets high returns from timing stocks. More generally, there are potential excess returns available in any asset class that doesn't look like an asset class, or any investment that isn't seen as an investment.¹

There's also a paradox of passive management, which gets more interesting. Passive works as long as there are investors keeping assets roughly aligned with the value of the underlying assets, but that takes time, effort, and a budget. And these traders need a counterparty to trade against, and for that counterparty to be able to change its mind; an active investor in an all-passive world needs to be very patient while they wait for their Tesla short or their small-cap bank long to pay off, if the only thing moving the market is passive flows. In other words, for this to work, active managers must have a clear path to getting paid: no hedge fund PM wants their analyst’s pitch to hinge on a “time will bail us out” short thesis.²

But that argument, too, requires some questionable assumptions. It's taking the existence of market-makers as an unstated premise; real-money investors are typically not trading directly with one another, but trading through market-makers who are in the business of quoting a bid and ask price. Are those market-makers active investors? If so, it's much easier to argue that they create alpha (and a world dominated by passive investing creates lots of opportunities for these market-makers to do interesting trades; different constituents of an index have different amounts of liquidity, so a market-maker might be willing to hedge a short position in the S&P 500 by only trading the most liquid members of the index, or might respond to index inflows by buying the least liquid index member on the grounds that it will react the most).

The private equity hypothetical above is a bit extreme, but there are market participants who don't quite count as being in "the market" but who do buy and sell shares. Companies can buy back stock. They can do secondary offerings or sell convertible bonds. They can tilt employee pay more towards equity rather than cash. And they tend to be opportunistic about this, or at least to hear from opportunistic bankers from time to time. Depending on the construction of an index, an all-passive market could see the most overpriced stocks continuously expand their share of the index by repeatedly issuing new shares, while the most underpriced ones continuously buy back stock until they disappear. But at that point, the index has engineered itself into being a low-return asset class, while private companies are where the upside is.

Importantly, none of these are stable equilibria. As passive grows, these kinds of mispricings endure for longer, at which point there are opportunities for active investors to get upside. Even if that doesn't happen, it means that the best investments don't make it to the market at all. And in an all-passive world, who is deciding where a stock should trade when it goes public? "All passive" can't really happen, and the closer the market gets the more logical contortions are required to describe how it would even work.

There's always a continuum between public and private, and that means it's always hard to define what market is being tracked by a passive investment. Go far back enough in history, and the process for making an investment in a public company is more complicated than the process of investing in a private company is today: making an AngelList investment requires a smaller amount of money in real terms, and takes fewer steps, than buying a share of the South Sea Company in 1720. Meanwhile, passive investing remains a good deal for anyone who either doesn't want to think too much about their finances or doesn't have a very good reason to believe they have an edge. In percentage terms, the most ruthless capitalists in finance aren't the people working for hedge funds, but the retirees whose Vanguard portfolios free-ride on all the hard work and risk-taking those analysts do, for just a few basis points a year. Active investing is, of course, lots of fun, and it's a socially valuable activity insofar as accurate market prices help everyone make better decisions. The active/passive debate is partly a real discussion about important market structure questions, but at the extremes what it really illustrates is that markets are complex and that the concepts we use to describe them are slippery.

Read More in The Diff

The Diff has written a few pieces on active and passive, including:

• We've looked at investment research as a way to identify and then answer the most important uncertainties about the future.

• Changes in market structure make it easier for passive to diversify, but also make it smarter for small discretionary investors to be more concentrated ($).

• It's hard to tell where passive investing is distorting prices ($), though there are some likely candidates.

• Even implementing an index leads to distortions that create trading opportunities ($).

And other changes in the market make now a very intersting time for individual investors willing to do legwork in small caps ($).

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1  Of course, these might never take off, or might not turn out to be a real asset class after all. Some such assets don't trade on a marketplace but do produce cash flows, like small businesses. But others are harder: if you're convinced that something counts as art, but art galleries aren't convinced of this, you might be buying and holding for a long time. Though with cheap not-quite-art, there's the hedge that you get a sort of dividend from owning something you enjoy looking at.

2  On the long side, with quality growth names, time is a pretty wonderful thing—a stock trading at a constant too-low multiple to some metric that grows at 15% annually produces a 15% annualized return with a potential kicker from re-rating. At least assuming the manager can hold on for long enough.