[MUSIC] Welcome to the third module of this course. The first lesson examines different methods in active management. Then we will discuss other issues that impact the way we can implement investment strategies and practice, namely the impact of trading costs and the impact of extreme events. We begin our discussion by comparing passive management to active management and understanding what it takes to be a successful active investor. In the second module, we saw that the simplest asset pricing model was the capital asset pricing model, in which the only risk factor is the market portfolio that contains all assets. While we now know that there are other risk factors that matter and that some temporary mispricings may exist, the market factor has a special place in finance and in investment management. Here's why. The aggregate portfolio of all investors is the market factor, the central piece of the capital asset pricing model. We collectively own the market and our collective performance is therefore equal to the performance of the market portfolio. The market is divided into two types of investors, passive and active. Passive investors hold a portfolio that mimics the market portfolio. That is, they place the same proportion in each asset as their proportion in the market portfolio. Passive investing does not cost much. You do not have to do any research on different companies to make a decision on your allocation. All you have to do is to replicate the market's allocation. Plenty of low cost index funds and exchange traded funds do exactly this. By construction, the aggregate performance of passive investors will be that of the market portfolio. The second type of investors are active. Being an active investor means that you adopt a portfolio allocation that is different from the market portfolio. A different allocation can be adopted by overweighting or underweighting a stock because you believe it is mispriced, by buying a risk factor other than the market portfolio because you believe it will perform well, or both. If all investor's collective portfolio is the market portfolio and passive investors as a group hold the same allocation as the market, then necessarily active investors as a group hold the same allocation as the market. If you overweight the stock in your portfolio relative to its weight in the market, then at least one other active investor underweights it in his portfolio. That brings us to our first important fact about active management. Active investors cannot collectively outperform the market. If the aggregate performance of all investors is equal to the market portfolio, and the aggregate performance of all passive investors is equal to the market portfolio, then necessarily the aggregate performance of all active investors is equal to the market portfolio. If you outperform the market by overweighting a stock in your portfolio, then necessarily another investor underperforms the market. For every winner there is a loser. If we put all fees aside for a moment, active management is what economists call a zero-sum game. In reality, things are a bit more complex. There are costs involved in acquiring information about different companies, predicting the economic landscape, or even selecting and hiring a talented fund manager. Therefore, when you consider costs and fees, active management becomes a negative sum game. When you take a specific bet on one or many stocks, outperforming the market means that another active investor underperforms. But it also means that both of your performances are reduced by costs. To be a successful investor, it is not enough to add expertise, a good understanding of investments and of financial markets, and good information. Your expertise, understanding and information need to be good enough to consistently beat other investors and cover the cost of acquiring this expertise and information. Similarly, if you hire an active professional fund manager to do it on your behalf, then he needs to be good enough to consistently beat the market and cover his fees. Bottom line, if you want to be active and successful in the long run, then you need to have a special expertise and competitive edge. But let's be clear on one point though. The negative sum game argument does not say that active investors don't create value, it's quite the opposite. Active investors, by gathering information about different investments in order to make proper allocation decisions, choose how capital is allocated in a society. Efficient capital allocation is crucial to economic development because it determines which projects get funded and at what cost. And that contributes to improving our standards of living. The economics of active management only says that active managers as a group cannot outperform the market, and that once costs are taken into account, active management is a negative-sum game. The goal here is to understand the difficulties faced when you decide to be an active investor. We need some investors to be active, do research, work hard to find information, and form opinions about different companies such that asset prices can form in the market. But the poor performance of the average active individual investor and of the average professional active fund manager points to the fact that it is hard for many to outperform on a consistent basis. You may well decide that you are better off investing in passively managed index funds, given the low fees that they charge. Otherwise, you need to clearly identify your expertise and competitive edge to become a successful active investor. In all cases you need to carefully consider the costs and benefits of your investment style. So let's wrap up with one question. Which of the following is true? A, passive investments are necessarily better because they have lower fees. B, actively managed funds are necessarily better because they use more information. C, active managers that outperform the market are better at using their expertise and lowering costs. Or D, passive investments are necessarily worse because you end up buying good as well as bad investments. The answer is C. Good active investors have special skills and expertise given the amount of cost in their strategies. If you are interested by active management strategies, then I invite you to continue with us. The next video describes a quantitative active management approach, sometimes also referred to as a systematic approach. Then we examine discretionary active management.