(September 30, 2013) — “I know I would be better off being passive,” said one Australian super fund CIO when surveyed for an active management study. “It’s a bit like eating McDonald’s—I know it’s bad for me, but still I eat it.”
According to the paper, “Why Do Investors Favor Active Management… To the Extent They Do?” written by Ron Bird, Jack Gray, and Massimo Scotti of the University of Technology, Sydney, investors predominantly flock to active management even though it does not add net value—and many of them know it.
The research was based on two surveys: one of Australian retirement fund CIOs and the other of asset managers and consultants. The results revealed that institutional investors over-allocate to active managers for a myriad of interconnected cultural, behavioral, and organizational reasons.
First, of the surveyed asset owners, about 55% had “extreme” active exposures of 90% or more. Only 20% had “extreme” passive weights, with exposures of 40% or more.
The divide was more significant internationally, with 65% of funds holding extreme active biases at 65% and 15% strongly favoring passive approaches, the research showed.
The CIOs’ stated preferences were in line with actual weightings.
More than 60% of smaller funds’ CIOs and staff said they preferred active management and believed 90% of their investment committees and consultants favored it. Larger funds, however, were less disposed to over-allocating to hands-on managers, with only 40% of CIOs and staff showing interest.
The data showed that very large funds with assets of over $15 billion were least likely to choose active management over passive and have a regular asset consultant.
So why are so many investors favor active managers over indexing?
Bird, Gray, and Scotti hypothesized five reasons: Investors are still unaware of the true cost of active management or of net outperformance; investors believe active managers will provide valuable downside protection if they underperform; investors have a bias toward activity and think it will help them be more competitive; investors believe hiring managers will bring extra utility past expected return and risks; and, investors are humans who require confirmation of their decisions and have overconfidence in manager selection.
From all of these reasons, the authors named behavioral impediments as one of the most significant.
According to the research, investors are overconfident in their ability to select successful managers while still needing confirmation of their choices. Active managers provide that comfort and give them the “illusion of control.”
When surveyed, CIOs ranked higher expected net returns and inefficient markets as the main rationales for choosing active management.
The study also found that defined contribution plans were more likely to prefer active management while defined benefit (DB) plans comparatively favored passive management. This is thought to be due to DB plans’ lesser concern for competition and stronger focus on liabilities.
Read the full paper here.
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