Is the active-vs-passive story really open-and-shut?

White paper explains flaws in arguments that active funds don’t or can’t outperform markets

Is the active-vs-passive story really open-and-shut?

While the war between active and passive strategies has generally been decided in passive strategies’ favour, it’s wrong to dismiss active managers as perennial losers, argues one new whitepaper.

In A More Balanced Narrative: Setting the Record Straight on Active Management, David F. Lafferty, CFA and chair of the Investment Adviser Association’s Active Managers Council, noted that drawdowns in active funds have been driven in part due an assault from many academics and practitioners, along with much of the financial media.

“[W]hile these attacks aren’t completely without merit, active management has been unjustly vilified,” he said.

One argument holds that active managers don’t outperform their corresponding benchmarks, which Lafferty said was based on subjective comparisons that differ based on underlying assumptions. For example, he noted that while the Morningstar Active/Passive Barometer found 59% of mid-cap growth funds outperformed the passive alternative for the three years ending 2018, the S&P Index Versus Active (SPIVA) report found only 46% of such funds outperformed.

“The dispersion between the two scorecards was even wider in small cap growth where Morningstar reported 51% of active funds outperforming to SPIVA’s 24%,” he said. “Active/passive performance comparisons can offer insight, but they are hardly precise.”

He also noted that while the difficulty US large-cap blend managers have had in outperforming is well documented, active management has proven itself in specific periods within certain areas like the US small- and mid-cap, emerging-markets, and foreign small-to-mid-cap equity spaces. He added that active outperformance has been cyclical, with active managers achieving alpha from 1990 to 1994, then in 2000 up to the great financial crisis in 2009.

The performance differences between active funds and their benchmarks, Lafferty argued, boils down to systematic differences between their respective holdings. “The broad differences in composition between funds and their benchmarks are often associated with factors that drive the relative performance of active managers over different time frames,” he said, citing market direction, market cap, and the credit environment as examples of relevant factors.

The paper also took aim at the argument that active managers can’t outperform their benchmarks, which assumes that alpha is a zero-sum game — that is, one investor’s gain is another’s loss. “[A] quick review of the empirical evidence indicates that, in many investment styles, the average alpha of professional active managers can be greater or less than zero before fees,” Lafferty said.

The zero-sum theory falls apart, he said, because it measures outperformance in dollar terms and on all assets. However, typical active/passive comparisons are not performed on a dollar-weighted basis (scorecards typically count the number of active funds that outperformed, not how much they outperformed by) nor in a closed system (put simply, not all assets in a specific investment category are held by mutual funds operating in that category).

“Slippage [in the accounting of assets in a category] can come from myriad places and asset owners, none of whose results show up in either the Morningstar Active/Passive Barometer or the SPIVA report,” Lafferty said. “[G]iven how success/failure is measured by the Morningstar and SPIVA scorecards, the zero-sum theory does not ‘prove’ the average active manager cannot outperform.”


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