Whatever else one might say about active managers, they typically don’t lack self-confidence. For example, a recent article suggested that “Whether it is stocks, bonds or other assets, an active manager with a rigorous top-down and bottom-up investment process and an outlook that vets the potential for a variety of both short- and long-term developments should be able to outperform a benchmark over time, adding value for investors.” This claim echoes those cited (mockingly) 20 years ago by Sharpe, and they weren’t new then.
Of course no one would argue that successful active managers don’t exist, in some cases famously so (Warren Buffett comes immediately to mind). The question is not whether successful active management is possible, but whether successful active management is prevalent. And here the advocates of active management argue two propositions:
• Active management “works” if it’s done well.
• If it’s not done well, the solution is to do it more aggressively. We’ll examine each of these propositions in turn.
DOES ACTIVE MANAGEMENT “WORK”?
Answering this question requires us to define what it means for active management to “work,” and that can be complicated— especially when we consider, as we should, risk as well as return. For our purposes, we’ll say that an active manager succeeds when he outperforms an appropriate passive benchmark. “Appropriate” is an important qualifier—among other things, it means that the benchmark should be consistent with the manager’s “natural habitat.” For example, if an active manager typically buys only small- and mid-cap stocks, his performance shouldn’t be compared to that of the S&P 500® or the Dow Jones Industrial Average®.
We can consider the prevalence of successful active management in both theoretical and empirical contexts. The theoretical argument begins with a tautology: the sum of the values of all investors’ portfolios must be exactly equal to the sum of the values of all stocks outstanding. From day to day, therefore, the change in the values of all investors’ portfolios must be exactly equal to the change in the values of all stocks outstanding. This means that the return of the average investor’s portfolio must equal the return of the average stock.