Efficiency Is Not Uniform
The case for passive investing is strongest where markets are most efficient. But efficiency is not a binary property — it varies across markets, asset classes, and time periods. Understanding where passive makes the most sense requires understanding what drives market efficiency in the first place.
Market efficiency depends on the number and quality of participants actively analysing a security. When thousands of well-resourced professional analysts are competing to identify mispricing in the same securities, the marginal value of additional analysis rapidly approaches zero. In such a market, the costs of active management are most punishing and the probability of finding a genuine edge is lowest.
The Case Is Strongest in US Large-Cap Equities
US large-cap equities represent the most compelling case for passive investing. The S&P 500's constituent companies are covered by more analysts, with more publicly available data and more sophisticated modelling tools, than any other market on earth. Price-relevant information is incorporated almost instantaneously. The residual opportunities for analysis-based alpha — if they exist at all — are tiny compared to the costs of the analysts required to find them.
SPIVA data confirms this: roughly 88-92% of active US large-cap equity funds underperform the S&P 500 over 15-year periods. For most investors, the default in this asset class should emphatically be passive.
Where the Case for Passive Weakens
The argument for passive weakens — though does not disappear — in less efficiently priced markets:
Small-cap equities: fewer analysts cover small companies. Information asymmetries are larger. Institutional investors often have capacity constraints that prevent them from holding small positions. In theory, there is more room for skilled research to add value. In practice, active small-cap funds still underperform their benchmarks at high rates — but the margin is somewhat narrower.
Frontier and emerging markets: lower analyst coverage, weaker disclosure standards, and less sophisticated local investor bases may create more persistent mispricings. Some evidence suggests active managers perform relatively better here, though the data is noisier and the costs are higher.
Private credit and infrastructure: these markets do not have efficient price discovery in the same sense as public equity markets. Lending relationships, bespoke structuring, and information advantages can be genuine sources of edge for skilled participants.
The Identification Problem Remains
Even in markets that are demonstrably less efficient, passive investing may still be the better choice for a specific reason: the difficulty of identifying skilled active managers in advance. It is one thing to know that some skilled active managers exist in small-cap equities; it is another to identify them before the fact rather than after. Past performance is a poor predictor of future performance even in less efficient markets.
A Decision Framework
A useful framework for evaluating active versus passive in any specific context: (1) Is this market demonstrably less efficient, based on structural reasons rather than hope? (2) Is there specific, verifiable evidence of persistent skill from this particular manager, beyond recent returns? (3) After accounting for higher fees, trading costs, tax drag, and the opportunity cost of not using the passive alternative — is the expected alpha still positive? In most cases, applying this framework honestly leads back to low-cost index funds as the default.