APPENDIX A [From The Quantification of Risk in an Upper and Lower Partial Moment

Fabric]
ACTIVE VS. PASSIVE INVESTING
Sharpe points out in his piece on equilibrium accounting,
If 'active' and 'passive' management styles are defined in sensible ways, it must
be the case that
(1) before costs, the return on the average actively managed dollar will
equal the return on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will be
less than the return on the average passively managed dollar
There is a very subjective classification underlying this aggregated assumption, a proper
definition of the terms active and passive. Sharpes definition of each term is as following:
A passive investor always holds every security from the market with each
represented as the same manner as the market. Thus if security X represents 3
percent of the value of the securities in the market, a passive investors portfolio
will have 3 per cent of its value invested in X. Equivalently, a passive manager
will hold the same percentage of the total outstanding amount of each security in
the market.
An active investor is one who is not passive. His or her portfolio will differ from
that of the passive managers at some or all times. Because active managers
usually act on perceptions of mispricing, and because such misperceptions change
relatively frequently, such managers tend to trade fairly frequently - - hence the
term active.
Is Sharpe's argument transitive; while passive undoubtedly infers less frequent, does less frequent
infer passive? We don't think so.
A recent market example will properly contextualize this. The energy sector's increased market
weighting over the last few years coupled with the financial sector's demise. The active investors
in the commodity arena started the cycle with crude oil contracts (reference the explosion of open
interest). The increased price of the commodity led to massive profits for the large integrated

oils and even sparked debate over a windfall profits tax. These increased corporate profits sent
share prices and market capitalization of these companies higher sending other active investors in
to exploit the perceived inefficiency of current prices. The passive investor then gets involved
due to the fact that they must keep relative market weightings. On their re-balancing (whatever
frequency), these passive investors are forced to buy these energy companies and sell financial
holdings. Buying performance at the expense of selling under performance does not bode well
for sustainable returns, in essence it's the inverse of buying low and selling high (the closest
semblance of a law this social science has).
These passive investors have participated in a less frequent manner, but their magnitude is what's
interesting. Does less frequency and greater magnitude as a function of the activity of the active
investors really then infer passive? No. It seems the only ones who truly prosper from this
example are the brokers or those active investors who initiated and then sold to the passive
investors forced in by their actions.
Active investing begets active investing if not by frequency then by magnitude, albeit passively.
If Sharpe's argument happened to spur some thoughts on how is it mathematically possible for an
individual to keep the market weighting at any point in time with a portfolio (outside of market
ETFs), don't fret because it is not possible with a finite amount of capital. To remedy this,
Sharpe aggregates all investors he defines as passive. This flawed logic is supported by more
flawed logic. Footnote 4 states,
"We assume here that passive managers purchase their securities before the
beginning of the period in question and do not sell them until after the period
ends. When passive managers do buy or sell, they may have to trade with active
managers, because of the active managers' willingness to provide desired liquidity
(at a price)."

When one buys or sells a security it usually happens at a specific date and time, thereby
becoming their reference point for that security. These footnoted passive managers do not have a
transaction reference point for their investments. Seems two wrongs make a right to Mr. Sharpe.
One last glaring inconsistency with Sharpe's analysis is his definition of passive. If a "passive"
fund receives inflows and re-balances monthly are they then classified as active because the
weighting in their portfolio will be diluted by those inflows during that period?
"An active investor is one who is not passive. His or her portfolio will differ from
that of the passive managers at some or all times."
If the inflows have effected a dilution of the passive manager from market weights for some of
the time, then they must be defined as active according to Sharpe. But I guess if you do not
consider the transaction a reference point for your investments, it really doesn't matter. It seems
the only way to achieve passive status is to inherit a market weight portfolio and to will it to
posterity upon your passing. However, the government rectifies this by forcing the recipient to
mark the portfolio's cost basis at the day of inception for tax purposes; therefore creating the
reference point Sharpe's argument assumes does not exist. Figure 8 illustrates the aggregate
market which indeed cannot have excess returns on itself, while Figure 9 illustrates Sharpe's
misclassification of investor types. Perhaps there is no such thing as a passive investor...only
degrees of active investors, which is foolishly ignored in the aggregate.