Active investing is an investment strategy in which investors trade based on preferences to outperform a given market. The market can be US stocks, international bonds, art, etc. In contrast, the purpose of passive investing is to match the market return. For example, to accurately match the return of the US stock market, a passive portfolio holds all the securities in that market in their respective market capitalization weights (value-weighted index of all assets). If a stock’s market capitalization amounts to 2% of the total US stock market, a passive portfolio tracking that market will have to allocate 2% to that stock.

For active investors to outperform the market, they must deviate from it. Hence, an investor must hold securities in distinct weights from the market-cap weights. Further, to beat, the investor will have to overweigh the securities that appreciate and underweight the ones that don’t. These deviations are called active weights. So, think of active investing as having preferences towards particular securities, sectors, etc., compared to their relative weighted portions in the market. Investors often establish those same security preferences based on perceived mispricing and differences in intrinsic value estimations.On the other hand, the best way to think of passive investing is as a copy of the market capitalization weights that all active managers have established with their preferences/valuations. Any index or manager not value-weighted has taken an active position compared to that market. That deviation from market weights implies that all the so-called strategic/smart beta strategies, factor investing, equal-weighted indices, etc., are technically active investments. Unfortunately, the media often confuses the term passive with systematic/index-based investing. 

Now that we understand what signifies being active and passive, the next important matter to realize is that someone always holds financial assets. There is no such thing as an unowned financial asset. This implies that for every security buyer, there is a seller and vice versa. Further, for every overweight in security, there must be someone underweight in that same security. Active investors establish the relative weights of securities in the market since they trade securities until prices reach the active investors’ respective intrinsic valuations. For instance, if all the active investors realize that a company is overvalued, they will begin to sell, causing the price to drop until the prices reach an undervalued level for other active investors. In this process, passive portfolios will also reduce their weight to the given security due to their reduced relative market capitalization compared to other securities in the aggregate market.

Let’s look at the below situation.

Imagine a $1 trillion equity market comprising 90% ($900 billion) passive investors and 10% ($100 billion) active investors. As we established earlier, the passive investors will copy the assigned relative securities weights of the active investors taken as an aggregate. To clarify further, the active investors’ community will decide that Apple’s market capitalization should be 2% of the market, Google’s 3%, and so on. In contrast, passive investors will copy those proportional weights for their portfolios. So, what would happen if the active investors were to go passive? For example, one way would be to imagine taking money from active investors and investing it passively. That switch would mean investing the money using the most recent market capitalization weights. If that were to happen, liquidity would disappear, as there won’t be anyone to trade with since everyone would take the last assigned valuations. As a result, the equity markets will be stale, holding the same relative companies’ weights, as there will be no one to set prices via their intrinsic valuations. 

So, why do we need active managers:

1. Establish relative valuations of securities: active managers determine their preference for securities, and given differences in perceived intrinsic values, they establish each security’s relative market capitalization. The aggregate active managers will trade until the market capitalization ratios are in “equilibrium”; securities are perceived to be priced appropriately. However, this does not mean that securities will trade at fair value since active managers only impact the relative values of securities, not the total market value. For example, let’s say active managers have decided that company XYZ intrinsic value is $100 billion, which represents 3% of the total US stock market. Suddenly, the optimistic population decides to sell $1 trillion in bonds and invest the proceeds in the US equity market (or the government prints a few trillion). Given this new net inflow, what will the active managers do? Their job is to invest the money; given company’s relative valuations have not changed, they will invest the new inflows in the exact prior relative weights. The inflows do not alter the proportionate intrinsic values and only adjust the total values. Assuming no active investors exit the equity markets, company XYZ will appreciate by $30 billion (net inflow $1 trillion * 3%). Active managers establish how securities should are valued correspondingly to each other, but asset class flows what determines the total market value/capitalization.
2. Provide liquidity: active investors provide liquidity when they update their valuations/preferences. As mentioned earlier, every asset or security is owned by someone. For those assets to trade, people will have to assign different valuations to them. For example, if everyone thought company A was worth $50 billion, there would be no trading of company A stock. For a trade to occur, one of company A investors must believe that the stock should be valued at $48 billion, and another investor must think that the stock should be valued at $52 billion. Only then the two investors will be willing to transact with each other. By having different “intrinsic” valuations and updating them, the active investors provide liquidity to the markets. 

To summarize:

What causes the buyers and sellers to trade with each other? What will cause someone to transact anything, not just financial assets? The answer is different valuations and different preferences. I have apples but prefer oranges, and you have oranges but prefer apples. The idea applies to every market, being a market for fruits, paintings, financial assets, and so on. A market is just a gathering where the exchange takes place. If active investors did not exist with their preferences, the financial markets would not exist.