The debate between active and passive investing has been a defining theme in financial markets for decades. On one side sits traditional active management, built on the belief that skilled managers can consistently outperform the market. On the other sits passive investing, grounded in the idea that markets are largely efficient and difficult to beat.
But as explored in this conversation with Slava Platkov, this binary framing misses something important.
The reality is more nuanced. Returns do not come from a single source, and understanding where they actually come from is key to building better portfolios.
At the heart of the discussion is a framework originally developed by Nobel laureate Robert Merton, which identifies three distinct sources of “alpha”—or outperformance.
The first is what most investors are familiar with: traditional alpha. This is the classic idea of active management—researching companies, forecasting outcomes, and attempting to identify mispriced securities. While intuitive, the evidence suggests that, as a group, active managers have struggled to deliver this consistently over time.
The second source is what might be described as factor-based or systematic returns. Rather than relying on forecasting, this approach focuses on identifying characteristics of companies—such as size, valuation, or profitability—that are associated with higher expected returns. These are not anomalies in the traditional sense, but reflections of how risk is priced in markets.
The third source is less discussed, but equally important: implementation. This includes the ability to capture additional value through how portfolios are constructed, traded, and managed—taking advantage of inefficiencies such as index rebalancing or reducing trading costs.
Together, these three sources provide a more complete picture of how returns are generated.
At first glance, there appears to be a contradiction.
If markets are efficient, how can investors expect to outperform?
The answer lies in understanding what efficiency actually means. Prices incorporate information quickly, making it difficult to consistently identify mispricing through forecasting. However, this does not eliminate differences in expected returns across the market.
Lower-priced assets, for example, tend to offer higher expected returns—not because they are mispriced, but because they carry different risks. In this sense, markets can be efficient while still providing opportunities for investors to position portfolios toward higher expected outcomes.
This shifts the focus away from prediction and toward structure.
Passive investing is often presented as neutral—a way to simply “own the market.” But in practice, there is no single definition of the market.
Every index is constructed using a set of rules: which companies are included, how they are weighted, when they are rebalanced. These decisions, while systematic, are still active choices.
For example, an index may include a fixed number of companies, exclude certain securities, or rebalance at predetermined intervals. Each of these decisions can introduce inefficiencies or unintended exposures.
Even something as simple as index reconstitution can create distortions. When stocks are added or removed, large volumes of capital move mechanically, often pushing prices away from fundamentals in the short term.
In this sense, passive investing is not free from decision-making—it simply embeds those decisions within a rule set.
Recognising these limitations, many investors have moved toward systematic approaches that sit between traditional active and passive strategies.
These approaches start with the broad market as a foundation, but then tilt portfolios toward characteristics associated with higher expected returns—such as smaller companies, lower valuations, or stronger profitability.
Importantly, this is not about identifying individual winners. It is about adjusting exposure across groups of securities in a disciplined, repeatable way.
The challenge then becomes one of implementation: how to capture these characteristics efficiently, without introducing excessive complexity or cost.
One of the more interesting perspectives from the discussion is the emphasis on simplicity.
While the investment industry has developed a vast array of factors and signals, there is a risk of overcomplicating the process. Adding more variables does not necessarily improve outcomes—particularly if those variables are unstable or difficult to implement.
Instead, focusing on a smaller set of well-understood drivers—such as size, value, and profitability—can provide a more robust and transparent foundation.
This approach also improves clarity for clients, making it easier to explain what is driving returns and why.
If there is one theme that stands out, it is the importance of implementation.
Much of the investment conversation focuses on ideas—factors, strategies, and models. But the real-world outcomes depend heavily on how those ideas are executed.
Trading, in particular, plays a critical role. Costs are unavoidable, and how trades are managed can significantly impact returns. Flexibility becomes a key advantage—being able to choose when and how to trade, rather than being forced to act at a specific time.
This is where systematic approaches can differentiate themselves. By maintaining diversified portfolios and avoiding unnecessary constraints, they can trade more opportunistically and reduce costs over time.
In many cases, this “implementation alpha” is as important as the underlying investment strategy.
The conversation also touches on private markets, an area that has attracted significant attention in recent years.
While there are clear diversification benefits, the range of outcomes across managers is far wider than in public markets. This creates a challenge for advisors, as selecting the right manager becomes critical—and time-intensive.
Benchmarking is another issue. Comparing private investments to broad market indices can overstate their performance, particularly if the underlying exposures differ.
As a result, while private markets can play a role, they require careful consideration—particularly around liquidity, transparency, and due diligence.
For advisors and investors, the key takeaway is not to choose between active and passive, but to understand the building blocks of returns.
Portfolio construction becomes a layered process. It begins with broad market exposure, then considers whether and how to pursue additional returns through systematic tilts or improved implementation.
The expected improvements may appear modest—perhaps an additional one percent per year—but over long time horizons, the impact of compounding can be significant.
More importantly, this approach provides a clearer framework for decision-making. It shifts the focus away from short-term performance and toward long-term structure.
The traditional active versus passive debate oversimplifies a more complex reality.
Returns come from multiple sources—forecasting, factor exposure, and implementation—and each plays a different role in portfolio outcomes.
Understanding these sources allows investors to move beyond labels and focus on what truly matters: how portfolios are constructed, how they are managed, and how consistently they can deliver over time.
In an environment where markets are competitive and information is widely available, that clarity may be one of the most valuable advantages of all.