Research finds a reason for active fund managers

Why do we pay fund managers to take our money and attempt to beat the market?

Both theory and experience say that paying for “active” investment management – which “actively” seeks to beat the market – is a self-defeating waste of money. We should instead put our money into “passive” index funds.

This has been well established for some two decades now. So, the existence of a vast industry devoted to trying to beat the market on our behalf seems baffling. Now fascinating research suggests that we are acting rationally when we give money to an active manager – though we may be gripped by a dreadful collective action problem.

I will short-circuit the theory for now. Let the common-sense argument for indexing suffice: in aggregate, stock markets are so totally dominated by institutions that the collective performance of active managers is equal to the overall performance of the market. Leaving aside front-end sales charges, they generally charge more than 1 per cent each year to pay for the research and salaries that go into beating the market. Index funds also get the overall performance of the market but generally only charge a fraction of 1 per cent. Let that gap in fees compound for a few years and index funds inevitably come out on top – which is indeed what all the performance data show.

Academics have shown this. Passive investment companies’ marketers have got the message out. The industry has produced new indexed products, such as exchange-traded funds or enhanced indexes, which are based on factors such as earnings or dividends or market value.

Yet old-guard actively managed funds cling on. By the end of 2008, only about 13 per cent of equity mutual funds in the US were passive, according to the Investment Company Institute. Outside the US, intermediaries do not even seem to have caught up with evidence in favour of indexing, and continue to balk at the idea because it means their clients cannot beat the market.

My own explanation for active management’s persistence has centred on inertia, ignorance (which suggests that we in the press are doing a bad job) and the incentives on intermediaries, who are generally paid more to sell an actively managed fund. In other words, I have tended to believe that active management is a racket built on exploiting investors’ ignorance.

Now academics have proved me at least partially wrong. It may be rational to hire an active manager. Lubos Pastor, of the University of Chicago’s Booth School of Business, and Robert Stambaugh, of the University of Pennsylvania’s Wharton School, recently published a paper arguing that active management is an “arms race”. Markets are not perfect. They have inefficiencies, which passive investors cannot exploit. Therefore it is rational to devote money to active managers to go out and find those stocks that are selling too cheap.

The problem becomes decreasing returns to scale. The more active managers there are, the less the chance they will find juicy mispricings. Others will have got there first. But if passive investors enter, they will amplify the markets’ inefficiencies once more, as they will dumbly buy whatever the index tells them. More indexers mean more opportunities for active managers.

If you are in the market looking for active returns, your best bet is to outlast the others. Once other active managers have given up, there will be more returns for you; if you give up first, someone else will benefit.

This is a collective action problem. The same logic often applies to gamblers. Mr Stambaugh, writing for Knowledge@Wharton, put it this way: “Most of us think that if we could just get the other guy to take his money off the table then there would be a better opportunity for me to outperform . . . We realise that if we pull out a lot, all we are doing is leaving money on the table for the guys who don’t pull out.”

So, rationally, what should happen is what has happened. Investment management is a young discipline – as recently as the 1950s individuals held more than 90 per cent of the stocks traded on the New York Stock Exchange. As the industry grew, active managers dominated. Then they grew too big and pushed against diminishing returns, so passive indexing grew. Collective action problems mean that active management’s share of the pie continues to be greater than it should.

What does this mean for savers? The arguments for index funds remain overwhelming. Yes, as index funds grow, they will create more opportunities for active managers. Active management will never go away. But when you entrust money to an active manager, make sure it is one with a specific plan to exploit a market inefficiency – not one just hanging on in hope that others will give up first.

‘On the Size of the Active Management Industry’, by Lubos Pastor and Robert F. Stambaugh