A New Conventional Wisdom on Active Management

September 12, 2018

The investment management industry has changed dramatically over the past 20 years. Passive investing has gained traction and has become a major factor in the markets, due to the growth in traditional index funds together with the introduction of exchange-traded funds. Active management has evolved as well. Most notably, the cost of active management has dropped significantly, as both fees and indirect costs have fallen.

But if so much has changed in investment management during the past two decades, why hasn’t the thinking about active management – and its value compared to passive management – evolved at all in that same period?

The conventional wisdom on active management was effectively established with the publication of Carhart’s “On persistence in mutual fund performance” in 1997. This much-cited study concluded that the data did “not support the existence of skilled or informed mutual fund portfolio managers.” It planted the seeds of the current negative narrative about active management, namely that it does not predictably add value for investors.

It’s odd that this narrative has remained unchallenged - given the large body of relevant academic literature that has been published since 1997. The value of active management has been a popular topic with researchers – a result of the visibility of mutual funds, combined with the ready availability of data about their performance and characteristics.

So it’s about time that a new review of the academic literature on active management has arrived, authored by professors Martijn Cremers, Mendoza College of Business, University of Notre Dame; Jon A. Fulkerson, University of Dayton, and Timothy B. Riley, Sam M. Walton College of Business, University of Arkansas. Titled, “Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds,” their paper cites close to 300 sources in a broad review of the research.

Their conclusion in their words:

“Taken as a whole, our review of current academic literature suggests that the conventional wisdom is too negative on the value of active management. The literature that followed Carhart (1997) has documented that active managers have a variety of skills and tend to make value-added decisions, such that, after accounting for all costs, many actively managed funds appear to generate positive value for investors. While the debate between active and passive is not settled and many research challenges remain, we conclude that the current academic literature finds active management more promising for investors than the conventional wisdom claims.”

The paper is a must-read for anyone interested in the current discussion regarding active management. After an overview summarizing the development of the asset management industry and the current conventional wisdom on active management, the authors take a deep dive into the literature on manager skill in U.S. equity funds. They survey the research that examines the level of active manager skill, whether skill can be identified in advance, the specific skills that managers bring to bear, and the market environments that make those skills most useful. The authors then review the studies of active manager skill in other types of mutual funds. The paper concludes with a discussion of the areas where additional research is needed: the appropriate model for measuring skill, how fund performance affects investor behavior, the data limitations facing researches, the difficulty of evaluating active management in multi-asset portfolios, and how the constraints on mutual funds may affect conclusions.

Here are our 5 key takeaways from the review:

Standard approaches to measuring skill may be biased against active management

If active manager performance is evaluated against a benchmark, conclusions about the value of active management are valid only if the benchmark is correctly specified. Unfortunately, the models most commonly used to define benchmarks have significant limitations.

The industry’s practice of subtracting index returns from unadjusted fund returns is easy to calculate but fails to account for differences in levels of risk. Holdings-based methodologies provide insights on stock selection skills but are constrained by lack of data and may not reflect the net return actually earned by investors.

Critically, the multi-factor model used in many academic studies, including Carhart’s 1997 paper, is sensitive to the choice of factors. For example, many researchers use size and value factors in their models, which places large weights on the performance of small-cap value stocks.

The limitations of the current models have led Berk and van Binsbergen, in a 2015 paper titled, “Meauring skill in the mutual fund industry,” to propose an entirely new measure of manager skill. Using their model, which looks at gross return in excess of the benchmark multiplied by assets under management, the average actively-managed fund generates roughly $3.2 million in value for investors per year.

Investors can identify skilled managers in advance

The academic literature suggests that finding skilled managers isn’t just a matter of luck; active manager characteristics and behavior are solid indicators of future performance.

Investment approach is particularly important. Notably, managers with a highly active approach – as determined by “active share” or other similar measures” -- are more likely to add value for their investors. Low turnover strategies, effective trading and a willingness to hold unpopular stocks are also associated with superior results.

Other viable predictors of outperformance are portfolio manager education and work experience, manager ownership of the fund and, yes, even past performance.

Active managers can pick stocks

Numerous studies conclude that active managers add value through stock selection, both on a fund-by-fund basis and at an aggregate industry level. This stock picking ability is most pronounced for stocks with high idiosyncratic volatility, for stock selection within industries and for the largest positions in a portfolio.

The source of this selection ability varies. Some managers can predict earnings, while some correctly judge post-merger performance, and others trade in advance of trends.

Active managers add value in many ways

But active managers do more than just pick stocks. Researchers have found that they add value through:

• Timing the market, including correctly anticipating changes in market volatility
• Using information effectively, particularly when they trade counter to public information
• Corporate oversight
• Tax management

Perhaps most importantly, managers add value through a disciplined investment approach. Singal and Xu, in a 2011 paper titled “Selling winners, holding losers: Effect on fund flows and survival of disposition-prone mutual funds,” found that funds with rational investing behavior were more likely to outperform and less likely to fail.

Economic and market conditions matter

However, the value of these skills varies with economic and market conditions. Active managers are more likely to generate positive risk-adjusted returns in recessions, when trading activity is high and when there is greater variation in returns among stocks.

Competition within markets also plays a role. Active managers are more likely to shine in markets and market sectors that are less popular.

The bottom line

“Challenging the Conventional Wisdom on Active Management” has two overarching themes.

• First, contrary to the current consensus, active managers can predictably add value for investors on a risk-adjusted basis.
• Second, traditional approaches to selecting active managers – which consider past performance, investment approach, manager characteristics and the investment environment – have validity because they can identify skill in advance.

Taken together, they confirm that the continuing investor commitment to active management is entirely rational.

“Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds” was supported by the Investment Adviser Association’s Active Managers Council.