What is the case for active management?

Question

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.

Answer 1

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:

One might suppose that to measure skill, one simply needs to measure the manager’s return before fees. The problem with this reasoning is that the fee the manager charges for services is only a small part of the costs of managing money. To achieve high returns, management must identify undervalued securities and trade to exploit this knowledge without moving the price adversely. In doing so, managers expend resources and pay bid-ask spreads that diminish the return available to pay out to investors. At some point, these costs increase disproportionately, eventually driving the managers’ expected returns down to the benchmark. To measure a manager’s skill level, one would need to measure return absent these costs, clearly something that we cannot do directly.

Berk shows that in equilibrium, the following seemingly plausibly hypotheses are false:

1. The return investors earn in an actively managed fund measures the skill level of the manager managing that fund.
2. Because the average return of all actively managed funds does not beat the market, the average manager is not skilled and therefore does not add value.
3. If managers are skilled, their returns should persist—they should be able to beat the market consistently.
4. In light of the evidence that there is little or no persistence in actively managed funds’ returns, investors who pick funds on the basis of past returns are not behaving rationally.
5. Because most active managers’ compensation does not depend on the return they generate, they do not have a performance-based compensation contract.

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:

Imagine an economy with skilled investment managers with differential ability who can generate positive risk-adjusted excess returns. Managers and investors alike know who these managers are. Assume that managerial ability to generate excess returns cannot be effectively deployed at an arbitrarily large scale. Eventually, the amount of money under management grows so much that each additional dollar contributed reduces the expected return of the portfolio as a whole. Certainly, this assumption is consistent with the observed decentralization of the professional money management industry.

How is the equilibrium determined in this economy? Who gets money to manage? Well, as investors know who the skilled managers are, money will flow to the best manager first. Eventually, this manager will receive so much money that it will impact the manager’s ability to generate superior returns, and expected return will be driven down to the second-best manager’s expected return. At that point, investors will be indifferent between investing with either manager, so funds will flow to both managers until their expected returns are driven down to the third-best manager.

This process will continue until the expected return of investing with any manager is driven down to the expected return investors can expect to receive by investing in a passive strategy of similar riskiness (the benchmark expected return). At this point, investors are indifferent between investing with active managers or just indexing, and an equilibrium is achieved. Notice that in this equilibrium all managers, regardless of their skill level, have the same expected return.

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".

Answer 2

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.

Answer 3

Directly from the Berk paper Five Myths of Active Portfolio Management:

"Even more surprising is the extent of what the average manager adds. The mean of the distribution in the Exhibit is 6.5%. Given a management fee of 1.5%, this means that the data are consistent with an alpha of 5% for the average manager.

"Of course, investors themselves never see this. Competition among them increases the size of the fund and drives the alpha to zero. Instead the managers themselves capture this value through the fees they charge."

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.