CFA Conference: The Puzzling Popularity of Active Management

The University of Chicago Booth School of Business offered this presentation examining the continuing popularity of active management. The moderator is David Barclay, COO of the Center for Research in Security Prices. The presenter is Lubos Pastor, Charles P. McQuaid Professor of Finance at the University of Chicago Booth School of Business. He is also a Research Associate at the National Bureau of Economic Research and a Research Fellow at the Centre for Economic Policy and Research. The focus of the presentation is why active management remains so popular. Note this article on this subject (more here).

My session notes follow.  As always, these are at-the-time notes.  I make no guaranty as to their accuracy or completeness.

  • Are there too many active managers?
  • Well-known stats — in 2011, 79% of large cap funds underperformed the S&P 500; the average equity fund lost 3% and the average hedge fund lost 5% v. S&P 500 being up 2%.
  • Even Peter Lynch now recommends passive investment.
  • Passive management now represents about 15% of the market.
  • Why is the active market so large given performance (the assumption is that people are stupid).
  • Pastor: It makes sense that the active market would be large even if investors are all smart.
  • Alpha becomes more elusive as more money chases it (competition to find mispricings).
  • Think of active managers as police officers and mispricings as crime.
  • With disappointing returns, investors change expectations and reduce active investment (but the reduction is cushioned by decreasing returns to scale!).
  • As passive management grows, active alpha will improve.
  • Past underperformance doesn’t imply future underperformance (just that some money should be moved active to passive).
  • Passive management should therefore only grow slowly (active should decrease slowly).
  • Without active management, there would be a lot of mispricings; thus at least some active management is optimal.
  • On an industry-wide basis, some active management makes sense; but does that apply on a personal/individual level?
  • As index funds get bigger, it will be easier for active managers to outperform.
  • Money to be made at the expense of index funds (e.g., buying ahead of an index reconstitution).
  • Burk & Green (2004): as funds get larger, it will be harder to outperform; Pastor agrees.
  • Passive management may need to grow substantially before we begin to see significant impact of the sort Pastor predicts.
  • CRSP has and will have some new index possibilities combining academic research and industry practice with objective and transparent measures (see here).
  • These indexes focus on investability.
  • Fewer U.S. securities since 2000 (down about 1/3); thus breakpoints (e.g., small to mid-cap) defined by cumulative market cap.
  • Bands around the breakpoints to decrease trading costs for passive managers.
  • Mega-Cap (top 70%; 284 stocks today)); Large (top 70%; 646 stocks today); Mid-Cap (70-85%); Small Cap (85-98%); Micro Cap (98-100%).
  • CRSP indexes and migration — considered many approaches; weighed trade-off between turnover and style-purity.
  • CRSP introduced the concept of “packeting,” which cushions movement between adjacent indexes (to reduce transaction costs).
  • Multi-dimensional approach to value and growth.
  • CRSP — Re-engineered market-cap-based indexes, emphasizing cost efficiency.

6 thoughts on “CFA Conference: The Puzzling Popularity of Active Management

  1. Pingback: CFA Conference: Post Compendium | Above the Market

  2. Interesting, so there is some equilibrium level for the division between active and passive management. I wonder what the equilibrium is.

  3. I do question active vs passive when active management slaps a brand label on 90% of the S&P via ETF’s (even mixed with a dash of bonds). However my question (or comment), are we grouping the active management in the specialty arena? I personally am all ears if I hear a high dividend chasing fund (ideal for my IRA), any commodity fund that goes past “gld”, real estate plays, or any third world awful country. So while an extra 100bps on a Managed Index ETF leaves me wondering what I am paying for, 200bp in Africa natural resources which a high turn over ratio seems like a play I want at least to hear out.

  4. A few comments:

    1) There has been no evidence that the results of active managers have improved as indexing went from 0% to 15% over the last 30 years, thus it is possible that the slope of the line is zero, meaning there is no correlation between the percent indexed and the alpha of active managers.
    2) For active managers to add alpha they first must make up -1.1% of negative alpha.
    3) IMO, the optimum mix between active and passive is 0% active and 100% passive. The only time this is not true is in asset classes where index funds are more costly and less diversified than active funds, ie the Vanguard Intermediate-term Tax Exempt fund.

    • @Rick Ferri – “0% active and 100% passive”: amen to that for all but a small fraction of managers and investors. The reasons that active managers outperform have been ennumerated countless times. Suffice it to say that, in addition to *not* being immune to the same cognitive biases that affect amateur investors and starting at negative alpha due to fees, active managers face additional pressures that whipsaw them and undermine their performance (daily NAVs, quarterly performance reviews, comparisons in magazines to unlike funds, hot money, the ability of large underperfomers to rest on their laurels due to stickiness, etc.) That being said, long-term money invested in value stocks and governed by processes that enforce investment discipline have been shown time and time again to outperform in the long run with less “risk” (however you define it, as long as your definition does not include measuring of relative or absolute volatility).

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