We hear about “going passive” plenty these days. It is understandable why — buying an index fund seems to remove some guesswork from investing.

With many active managers available, how will investors know they’ve selected the right one? Easier to buy ‘the market’, right? And don’t mutual funds collectively underperform their benchmarks after fees? Why pay higher fees for uncertainty and potential disappointment when you could buy an index fund and lock in the market’s (fee-adjusted) return?

This thinking has propelled the growth of the passive fund industry.

But as the passive segment grows, the opportunities for active investors should only improve. While global equity markets as of the end of 2014 still offered great value (compared to generally expensive, low-yielding fixed-income assets), that value is becoming increasingly selective. After a rebound from 2009 lows, the beta rally and future performance could become more alpha-driven and stock-specific.

Buying indiscriminately in such an environment seems a dubious strategy.

The problems with passive funds aren’t merely situational. Several structural limitations could result in value destruction over time. Consider the basic investing premise: buy low, sell high.

Yet, passive funds tend to do just the opposite. Many are market capitalisation-weighted. To stay in line with benchmark allocations, passive funds buy more gaining stocks, selling losing stocks, thereby perpetually rotating away from cheaper underperforming stocks to more expensive stocks with limited upside. Buying an index fund exacerbates supply and demand imbalances by perpetuating momentum.

Because passive funds take no view of business fundamentals or valuation, they bear unnecessary investment risks.

Focusing on yesterday’s winners means that capital gets allocated in passive vehicles dependent on size, not expected returns or growth rates. Allocating capital thus perpetuates overvaluation, erodes competition and impoverishes free market capitalism. Without active managers practicing due diligence and facilitating price discovery, there’s no market for an index tracker to track.

Ultimately, this may be self-curtailing, as inefficiencies created by passive’s growing market share increase opportunities for active managers to allocate capital where most productive. Finally, passive products often guarantee underperformance versus the market after fees.

This is a non-starter. We won’t maximise real return potential over time if we’re compounding underperformance into perpetuity.

The main point supporting passive funds is: “active managers usually fail to beat the benchmark after fees”. This is less a critique of active management than a recognition of a simple mathematical reality. Paraphrasing William Sharpe in ‘The Arithmetic of Active Management’, the cumulative sum of all investments equals the market return, which nets out to underperformance after fees.

This simple adding-up constraint has been misappropriated as a rhetorical pillar against active management.

The “active management industry” includes managers who aren’t really all that active. In a study, Yale professors Martijn Cremers and Antti Petajisto devised a measure called ‘Active Share’ to gauge manager ‘activeness’ or how different a portfolio is from its benchmark. A pure index fund mirrors its benchmark and has an Active Share of zero.

A fund holding none of the benchmark securities has an Active Share of 100. What was surprising about the findings wasn’t how few managers beat the benchmark, but how few actually seemed to try.

The findings showed that some 1/3 of US mutual funds had low enough Active Share to be considered ‘closet indexers’ (portfolios hugging their benchmarks in attempt to protect relative performance in a volatile, competitive marketplace). The risk in looking different than the benchmark is that performance deviates from the benchmark.

Deviating from the benchmark is the only way a portfolio can outperform. Yet, the study found that the share of assets held in truly active funds had fallen from 60 per cent in 1980 to under 20 per cent in 2009.

Truly active funds do outperform their benchmarks on average even after fees and expenses. Found that long holding periods are nearly as important as high Active Share to securing investment outperformance. Yet, the current vogue seems to be away from long-term managers specialising in active security selection.

This flies in the face of academic research. Quoting MIT’s Mark Kritzman and Sebastien Page’s study, ‘The Hierarchy of Investment Choice’, “Security selection is the most important investment choice, and skill as a security selector has the greatest value.”

Simply put, active managers with distinctive contrarian styles and long-term investment horizons can prove beneficial, as supported by academic research, firmly rooted in empirical evidence.

The writer is Chief Investment Officer at Templeton Global Equity Group.