I have been leaning towards passive investment for sometime, but I had not seen any evidence or argument that helped decide whether tracker funds or buy and hold mechanical strategies were better. Thanks to the Behavioural Investing blog I found this illuminating paper.

The evidence seems pretty clear: the constant re-balancing required to track the index destroys value. The problem is that over-valued shares join the index, only to subsequently under-perform.

This seems to be partly due to the value effect: the highly rated shares that joined the index under-performed the lower rated shares that were ejected.

So far, it seems clear that a portfolio that closely reflects a market index at the time it is constructed, and that is then left alone is likely to out-perform the market. Can we do better than this?

I have previously written about the value and size effects, and I would favour investing in either:

• a value style index tracker, or, better, a small cap value index tracker, or
• a mechanically selected portfolio of (again, preferably small cap) value shares.

I cannot tell which is better. Although the re-balancing of market index trackers is a loser, the re-balancing done by style index trackers serves a purpose (replacing shares that are no longer value with those that are), so it may be worthwhile.

I would probably be inclined to go for the mechanically selected buy and hold portfolio, trading only when a holding ceases to be value share, but, right now, I do not have any evidence which approach would be better.