Report: Active Management Will Always Have a Place in 'Mostly Efficient' Markets

A newly released report -- furthering the debate between active and passive management -- concludes that while finding superior active managers is not easy or simple, it can be done. 

(December 20, 2011) — A new academic paper providing further fuel to the active versus passive management debate asserts that investors who can identify superior active managers (SAM) should be able to improve their overall Sharpe ratio by including a meaningful exposure to active strategies.

“Most debates have a clear winner: Lincoln beat Douglas, Kennedy beat Nixon, and Reagan beat Mondale. But the debate surrounding active versus passive management continues to rage after more than 40 years of contention,” asserts Robert Jones of Arwen Advisors and Russ Wermers of University of Maryland’s Robert H. Smith School of Business in their paper titled “Active Management in Mostly Efficient Markets.” 

In response to why active management is here to stay even though, according to many academic studies, the average active manager doesn’t add value, Jones told aiCIO: “Its the combined activity of all these active managers that keep markets efficient and thereby hard to beat, and efficient markets mean better capital allocation, and thus greater growth and wealth for society as a whole. To reap this huge benefit, markets must encourage active management, which they do by heaping huge rewards on SAMs. Our paper also highlights that it may be possible for fund investors to identify SAMs in advance based on various metrics and characteristics.”

According to the authors, the research paper aims to answer the following three questions:

1. Does active management add value?

2. Can we identify superior active managers ex ante?

3. How much active risk should investors include in their portfolios?

The paper concludes: “If we assume that the aggregate of all actively managed funds is equal to the market—that is, active management is a zero-sum game—then the aggregate of active fund returns equals the market return but incurs trading costs and charges fees, and so the aggregate will underperform the market by an amount equal to fees and expenses. Empirical studies seem to broadly support this conclusion…Active management will always have a place in ‘mostly efficient’ markets. Hence, investors who can identify SAMs should always expect to earn a relative return advantage. Further, this alpha can have a substantial impact on returns with only a modest impact on total portfolio risk. Finding such managers is not easy or simple—it requires going well beyond assessing past returns—but academic studies indicate that it can be done.”

The report jibes with recent remarks by Sam Kunz, head of the Chicago Policeman’s Annuity and Benefit Plan, who spoke with aiCIO earlier this year about international pension differences, mushroom hunting, and overconfidence. “In Switzerland, mushroom hunting is very popular. In the fall, there is a high probability there will be mushrooms when the sun is shining just after rain. But perfect conditions don’t guarantee you will be successful in finding any. The same holds true for active management,” he said. “At any given point of time, there are inefficiencies somewhere available to someone, but it doesn’t mean that investors are able to capitalize on them. In other words, markets might not be efficient, but the trick is to be able to take advantage of that inefficiency despite its versatility. Therefore, the budget for active management should be spent very wisely because our ability to consistently capture these opportunities is low.”

Giving light to the opposite side of the debate, research released earlier this year — carried out by students at Uppsala University — showed that if the stock market is on the upswing, then a passive management approach across a broader market index may be superior to an active approach. The study revealed that during periods when the stock market was on an upswing, actively-managed funds faced difficulty outperforming the index. However, during falling stock markets, actively-managed funds were more likely to outperform the index.

Undoubtedly, the active versus passive debate has been a popular topic within the institutional investor world. Mirroring the Stolkholm-based study, Lee Partridge, San Diego County Employees Retirement Association’s (SDCERA) outsourced portfolio strategist and CIO at Salient Partners, offered a skeptical tone. “We think that it’s important to get all the different strategies represented in a well-diversified portfolio…but are you really trying to bring in the return premium that comes from those strategies, or do you think the manager has skill over and above the strategy?,” he told aiCIO. “We think that both can be operable, but we’re fairly skeptical about skill. We think that skill really has to be proven and it’s very difficult to detect.”