A recent personal finance question asks when to hire an investment professional? Given that many of us here are on the professional manager side of the business, how would you make the case? What quantitative evidence would you show a potential client? What research is there to guide one as to the right asset level at which to switch from do-it-yourself investing to hiring a professional wealth manager? Are there reasons besides investment returns to make the switch (e.g., tax, retirement planning)? Keep in mind that most investors, unlike us, are not interested in spending a significant chunk of their lives thinking about investment decisions.
There's a strong theoretical argument that makes the case for active management that is also supported by empirical research. First, check out Jonathan Berk's paper "Five Myths of Active Management". The paper reads like a clever Gedankenexperiment.
Starting with a theoretical approach is better than starting with an empirical approach because as Berk points out:
Berk shows that in equilibrium, the following seemingly plausibly hypotheses are false:
His point in a nutshell is that in equilbirium the excess returns (after fees) of active managers is driven down to the return from indexing/passive management. The first $XYX dollars under management generate alpha but at equilibrium the manager has taken on enough funds such that the marginal invested dollar does not.
Excerpt of the argument:
Berk goes on to relax the assumptions and offers a more realistic experiment. Then he proceeds to cite his 2004 paper "Mutual Fund Flows and Performance in Rational Markets" where he empirically models indirectly the value-added from managers and finds that "the vast majority of active managers add value" and "80% of mangers generate value in excess of their fees".
An active manager can be good for a few reasons.
They can scale resources much better than an individual investor, and as a result can get better execution prices and access to assets that would be impractical for some individual investors(unsponsored foreign listings comes to mind).
Better firms will have tax professionals available to minimize taxes and therefore increase returns - whatever it takes to beat the benchmark, right?
Also, it might be worthwhile to look at a manager who has a contrary style to your own. This can offer a hedge of sorts and may supply opportunities you otherwise wouldn't undertake.
Directly from the Berk paper Five Myths of Active Portfolio Management:
The second paragraph is especially telling. From the investor's perspective, active managers provide no value in terms of return. Berk himself is saying exactly this. With this conclusion there are then many reasons why active management is a negative for investors (style drift, fees, etc.). This paper only serves to strengthen the argument that participating in active management is a loser's game for investors.