Liquid Equity Market Investing: Passive or Active?

This research note is produced by Elkstone in conjunction with our hedge fund and cta manager database partner, Nilsson Hedge.

  • We typically access the liquid equity markets via ETFs.
  • We rarely invest in active management or stock picking within the liquid equity markets.
  • We are very active in stock picking within the private, equity market and co-invest in our deals.

The active or passive debate will likely never be settled. Passive management is where no investment decision needs to be made as your investment simply tracks an index; while active management employs a decision-based approach to change the portfolio in order to attempt to outperform the market. The fund manager camp argues active is best and that by picking stocks, they can beat the market over a market cycle and thus earn their relatively higher fees. The other camp says that active stock picking is like gambling, and every gambler can get lucky here and there but over the long run will lose.

At Elkstone, our investment philosophy has us:

  1. Requiring a positive return expectancy,
  2. Looking to achieve exposure to the desired markets and risks in the cheapest way possible,
  3. Looking for diversification when diversification is needed,
  4. Looking past the name of the market, strategy, investment process and investment vehicle type to analyse what risks and exposures are actually driving the return stream.

Oftentimes a return stream can sound different and therefore diversifying, but is driven by the same underlying drivers and is therefore not additive to a portfolio.

With this investment philosophy as governance, this short research note looks at whether we want to build our internal equity investment strategy through passive or active management and through ETFs or alternative investment vehicles.


As we always look at what we are getting from both a market/strategy and investment vehicle, we understand that with an ETF vehicle, we will get the following:

Trade Setup: Long/buy-only exposure
Cost: Cheap exposure relative to other investment vehicles
Liquidity: Daily liquidity and high volume
Management: Passive


An equity index is a basket of stocks that are set by definition, for example, the largest 500 US companies based on market capitalisation; that index will always have the largest 500 stocks within it. When we think about what an equity index, like the S&P 500 or the DAX 30, is providing us in terms of its characteristics, we come to the following understanding:

Market Support: Equity markets are incentivised to be long-term increasing; this comes from both fiscal and monetary policy support. The presence of this support has never been so clear than since the Global Financial Crisis [‘GFC’].

Survivorship Bias: Within equity indices, there is a survivorship bias that lends to a structurally long-term increasing market affect. The S&P 500, or the DAX 30 for example, always tracks the largest 500 or 30 companies, respectively. If a company within the index performs so poorly that its market capitalisation means it’s not in that top group anymore, that stock leaves the index and is replaced by the next company that meets the criteria. We now get exposure to that new company and its gains until something similar happens again – take Lufthansa or Kodak as a recent example of this survivorship bias that we benefit from.

Embedded Strategy: Due to the market capitalisation weighting structure of equity indices, there is an embedded momentum-type strategy that investors get exposure to; if a stock performs well, its market capitalisation goes up and as a stock performs poorly, its market capitalisation goes down. As the index is weighted off market capitalisation, the better performer has a bigger impact on your return than a worse performer has. The S&P 500 is driven by its top 5 companies which currently account for around 25% of the total weighting which is why the index was up during 2020 when the average return [evenly weighted or average company return] was down.

Systematic Risk: Theoretically, an equity index [diversified group of stocks] should only provide us exposure to systematic [‘market’] risk and none to idiosyncratic [‘individual company’] risk as it’s diversified away. An argument can however be made that due to the embedded strategy above and the weighting structure, you are significantly exposed to the biggest stocks as they have an outsized affect on the index from a weighting perspective.

Given the market structure and characteristics outlined above, we believe that there is a positive return expectancy within equity markets and equity indices, i.e. They are long-term increasing and expected to continue in that manner. Chart 1, Chart 2 and Chart 3 below looks at the Dax 30, S&P 500 and the MSCI All Equity Index since 1991, 1991 and 2007 respectively. Given that we believe there to be positive expectancy, we should see money invested over the medium term, regardless of when we invested be profitable. Within each chart, an ‘X’ was added right before the past three significant equity market drops to add strain to this hypothesis. If we had invested in any of the equity indices right before any of the equity drops, we would have made a positive return on our investment as it stands today and before the next significant market drop.

Chart 1: Dax 30 since 1991

Source: Elkstone Private, Bloomberg

Chart 2: S&P500 since 1991

Source: Elkstone Private, Bloomberg

Chart 3: MSCI All World Equity since 2007

Source: Elkstone Private, Bloomberg


Our investment philosophy requires access our desired exposure for as cheap as possible; ETF access to equity markets is our way of doing that, but we understand that there are other tools to access equity market exposure, so we look at active management for stock picking to see if they can bring in an added return stream within our equity block that meets our investment philosophy.

Equity markets are the best-known investment market. Every asset manager has products within active equity management while they tell you they can outperform based on their unique fundamental or quantitative process. With thousands of equity products, billions invested in actively managed equity investing and millions spent in infrastructure and R&D, it is the most competitive market out there to squeeze out the famous alpha return.

Given the liquid, transparent and efficient nature of equity markets combined with the highly competitive environment that is stock picking, we set out to see if stock picking does provide us increased and uncorrelated returns to warrant active management inclusion in our equity block. To analyse this, we look at Equity Long Short managers who pick researched individual stocks to buy and sell as a benchmark for stock picking performance. Chart 4 below shows an Equity Long Short index performance after stripping out the manager’s returns that are driven by the general market, i.e. What we have exposure to from our ETF. We can see that outside of general market returns, stock picking did not add any positive return.

Chart 4: Equity Long Short Stripped of Market and Equity Factor Risk

Source: Athlon Family Office, AlphaWeek: ‘Equity Long Short Provides Portfolio Protection – Truth or Myth?’

The most common argument against this finding is an investor or manager coming to us saying, maybe they don’t outperform in general, but I’m invested in, or I know, Fund X that did really well in 2020 when the market didn’t do well, so their stock picking did outperform and bring in alpha. That may be true however this research is showing that over a 10-year period, they will likely even out to no alpha generation. Just because they did well in 2020 doesn’t mean they will do well in 2021 and 2022 and 2023 and so on. We ran some research on this hypothesis.

Table 1, Table 2 and Table 3 below are taken from a research note that analysed how picking the best and worst performing managers from extreme market years performed for the following three years compared to the benchmark. What is witnessed is that there is a lack of consistency in continued outperformance and what is most common is that the managers that outperformed recently end up underperforming against the benchmark in the following three years. To put it a different way, just because they did well previously or during a particular year, doesn’t mean they’ll do well in the future.

Table 1: 2008 Best & Worst Performing Managers

Source: Athlon Family Office, CAIA: ‘Picking Top Performers: Does History Tell Us the Future’

Table 2: 2013 Best & Worst Performing Managers

Source: Athlon Family Office, CAIA: ‘Picking Top Performers: Does History Tell Us the Future’

Table 3: 2018 Best & Worst Performing Managers

Source: Athlon Family Office, CAIA: ‘Picking Top Performers: Does History Tell Us the Future’


We are guided by our investment philosophy, and it is based on that philosophy that market, strategy and investment vehicle decisions are made.

Explainable Positive Expectancy

  • Does public equity market’s systematic risk have positive expectancy? In our opinion, yes.
  • Does stock picking/individual company risk within the public equity market have positive expectancy*? In our opinion, no.

Look past the name of the strategy, market, investment process and vehicle

Just because the names of the vehicles are different, doesn’t mean we are getting different return drivers:

  • ETF return driver(s)  =  market risk
  • Equity LS/Active Management return driver(s) = market risk + individual company risk

Access desired market or risk exposure in the cheapest possible way

As we don’t believe there to be a positive expectancy in the individual company risk component, we want access to the market risk component of the Equity LS manager’s returns, and we want to get that exposure in the cheapest and most liquid way possible. ETFs get us that exposure far cheaper than Equity LS manager fees which is why we concentrate our liquid equity market exposure only in ETFs and rarely through active management.

As with every rule, there are exceptions and there are three worth highlighting from us:

  • Active performance is hurt by strong broad market runs. This has been driven by Central Bank policy in North America. When this force/support leaves and we see a market environment closer to 2000-2010, there will be a case for active management/stock picking over ETF investment, and we stand ready to change with the times.
  • Despite our finding that company risk does not seem to have a positive expectancy in general, we have identified a specific strategy that we believe provides positive expectancy on the company risk component for explainable reasons and that strategy is within our hedge fund portfolio.
  • Despite company risk to be found to not have positive expectancy in public equity markets, we do believe there is significant positive expectancy in stock picking within the private equity markets and for explainable reasons. Due to this, we have a very active illiquid venture/private equity book and provide this deal flow with our family office clients for co-investment in. A future piece will discuss this in greater depth.

Equity Long Short Provides Portfolio Protection – Truth or Myth?
Picking Recent Top Performers: A Strategy or Bias?


Karl Rogers is the Chief Investment Officer of Elkstone Private. Elkstone is a family office managing the wealth of its principals, with a focus on real estate, venture and alternatives, and a Multi-Family Office, regulated by the Central Bank of Ireland, which provides both access to co-investing in our principals’ investment portfolios and traditional family office services to many of Ireland’s entrepreneurs and HNWIs. Previously to Elkstone, Karl was a Managing Partner with Athlon Family Office, Head of US Power Trading with RISQ, Managing Director of ACE Capital Investments, a hedge fund manager and a proprietary commodity trader.

Karl currently sits in the adjunct faculty for Trinity College Dublin’s M.Sc. in Finance program where he is both a guest lecturer in their alternative investment module and supervises the student’s theses and he is a Special Advisor to the ESG Foundation.

Karl has been referenced in major industry publications including the Wall Street Journal, Bloomberg and the Financial Times and has spoken at numerous family office and alternative investment conferences across multiple continents.

Connect with Karl on LinkedIn.