The debate over active versus passive investing has spurred numerous studies, which in turn, have produced many thoughtprovoking theories on the subject. Despite countless data, sophisticated statistical techniques, and brilliant researchers tackling the issue, there are few palpable and universal conclusions one can draw from these studies. This is somewhat predictable given that these studies use unique data sources, evaluate different periods, and employ diverse statistical methods—not to mention are subject to human biases. As such, we are not brash enough to claim that we could conduct a better study as we would be subject to these same shortcomings, including our own biases. Rather than recreate analysis that has been recreated many times over already, we are going to focus on the few common findings from these studies that appear to be largely undisputed. We will first describe these conclusions, illustrate why they exist, and then explain why we believe markets are inefficient and why active management can add value net of fees.
I. The Three Findings
After reviewing innumerable research papers that dissect the benefits and drawbacks of active and passive investment management, we have identified three results that appear to be widely acknowledged as fact:
Fact 1: The average active manager has underperformed the passive benchmark after fees
Fact 2: Some active managers have demonstrated ability to outperform the passive benchmark after fees
Fact 3: High conviction is a common characteristic among active managers that have outperformed
Fact 1: William Sharpe’s 1991 article in the Financial Analysts Journal asserts:
“…it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also”. After fees, therefore, the average active manager should underperform the passive index due to those higher fees. Empirical evidence from the studies we reviewed supported Mr. Sharpe’s proclamation.
Fact 2: Here is another passage from the same 1991 article:
“It is perfectly possible for some active managers to beat their passive brethren, even after costs.”…”It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs.”
Again, empirical evidence from the studies we reviewed supported Mr. Sharpe’s contention. The magnitude of that outperformance, however, and its statistical significance are factors without universal and conclusive acceptance. The important takeaway is that while it is true that the average manager underperforms after fees, not all managers are average.
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