Information, Uncertainty, and Active Investment Management

The rise of passive investing has diminished the perceived value of active management. This is driven by the belief that finance theory favors indexing and that expected alpha before costs is always zero. This article challenges that view by tracing the evolution of asset pricing models to include those that do not require all investors to hold the same portfolio of risky assets, highlighting limits to market efficiency, and examining the implications of information costs and investor heterogeneity. It argues that finance theory increasingly supports active investing. Drawing on Frank Knight’s and Frederich Hayek’s insights, the article distinguishes measurable risk from unmeasurable uncertainty and quantifiable from unquantifiable information. In this context, alpha arises from navigating uncertainty using unique, costly, and judgment-driven insights. The article recommends that investors diversify across information sources, grant flexibility to managers, and avoid overly narrow mandates. The authors conclude that uncertainty is a persistent feature of markets, and that thoughtful, adaptive active management remains essential for aligning portfolios with investors’ unique objectives as well as for capitalizing on inefficiencies.