The attached paper, Challenging Conventional Wisdom of Active mgmt *, undertakes a review of the most recent academic literature on active equity management.  It concludes by challenging the conventional wisdom of active management.

 

The conventional wisdom of active management, which is based on research over 20 years old, runs along the lines of the following:

1. The average fund underperforms after fees.
2. The performance of the best funds does not persist.
3. Some fund managers are skilled, but few have skill in excess of costs.

 

Nevertheless, a review of the current literature finds a substantial body of research that disagrees with the conventional wisdom of active management.

 

The authors of the paper conclude “taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management.

The literature that followed Carhart (1997), the basis of current conventional wisdom of active management, has documented that “active managers have a variety of skills and tend to make value-added decisions, such that, after accounting for all costs, many actively managed funds appear to generate positive value for investors.”

“While the debate between active and passive is not settled and many research challenges remain, we conclude that the current academic literature finds active management more promising for investors than the conventional wisdom claims.”

 

Quoting from the paper’s introduction:

1. “Regarding average performance, Berk and van Binsbergen (2015) find the average active fund outperforms an equivalent index fund by 36 basis points per year, while Cremers, Petajisto, and Zitzewitz (2012) and Linnainmaa (2013) show that standard approaches to estimating average fund performance can be biased against finding that active management adds value.”
2. “Considering performance persistence, Bollen and Busse (2005) and Kosowski, Timmermann, Wermers, and White (2006) both find some evidence of persistence among top-performing funds.
3. “Several studies identify groups of funds that appear to have skill in excess of costs. For example, Cremers and Petajisto (2009) show that funds with ‘high active share,’ meaning funds with holdings that greatly differ from their benchmark, tend to outperform their benchmark. They also show that the performance of funds with low active share drives the results of previous studies indicating that the average actively managed fund underperforms. Similarly, Amihud and Goyenko (2013) show that funds with past performance that is not readily explained by common factors, such as the performance of large-cap stocks versus small-cap stocks, perform well in the future.”

 

“The research has also considered how the actions of active managers create value in different ways. Wermers (2000), among others, shows that many funds select stocks that outperform the market, while Kaplan and Sensoy (2005) and Jiang, Yao, and Yu (2007) show that some funds can correctly time the market. Other research finds that active managers create value through corporate oversight (Iliev and Lowry, 2015) and tax management (Sialm and Starks, 2012). The returns on these activities vary; Pastor, Stambaugh, and Taylor (2017) and von Reibnitz (2018) show that the amount of value creation depends on market conditions. “

 

It must be remembered that it over 20 years since the publication of Carhart’s landmark study on mutual funds.  Its conclusion—that the data did “not support the existence of skilled or informed mutual fund portfolio managers”—helped form the ‘conventional wisdom’ that active management does not create value for investors.

 

20 years on, this paper could well be a landmark paper and is well worth reading.

 

I don’t want to enter the passive vs active debate. I find it very dogmatic. From personal experience I can see a place for both passive and active management, including the use of Exchange Traded Funds and alternative investment strategies. There are active managers who can consistently add value, nevertheless they are rare.

I do think some people hold on to some pretty outdated views on active management and analysis based only on US Mutual Fund data may have its limitations.

 

Often it is hard to identify successful active managers. A recent paper from a very well respected British university concluded that Asset Consultants were not very good at identifying successful managers.  Nevertheless, their research results showed that active managers did outperform on average!!

 

With regards to fees, see my Post, Investment Fees and Investing like an Endowment – Part 2.

 

From my own investment management experience there are a couple of guiding principles I always reflect upon, which I think are relevant for the active vs passive debate:

1. Beware of Hubris before the fall
2. “It is better to be roughly right than precisely wrong” quote attributed to John Maynard Keynes

 

Happy investing.

 

*The paper is: Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds, K.J. Martijn Cremers, Jon A. Fulkerson, and Timothy B. Riley, September 2018.

 

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