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.