Why having more skilled active managers could hurt returns

Why having more skilled active managers could hurt returns

Why having more skilled active managers could hurt returns

Active managers are valued and compensated based on their ability to beat the market, so one would think investors in active funds would be better off if all their managers were skilled. On the other hand, it wouldn’t be so good for the asset management industry at large.

That’s the conclusion drawn by new research published by a US-based economic think tank.

“In a new paper for the National Bureau of Economic Research, Wharton School professor Robert Stambaugh argues that more skill across the board would result in lower excess returns,” reported Institutional Advisor.

The trouble, according to the research, is that there would be more skilled investors accurately recognizing and trading mispriced securities. The more money there is chasing the same ugly ducklings and hidden gems, the less potential there is for alpha.

“[The] collective higher demand for [an underpriced stock] raises the price managers pay for it, reducing the investment profit they make from buying it,” Stambaugh wrote.

As Institutional Investor noted, this can hurt active managers whose compensation is tied to market outperformance; it would be particularly painful for those faced with a hurdle rate they must surmount before they can start collecting performance fees. Should more managers become more skilled to the point that they were evenly matched or comparable, Stambaugh said, a scenario of lower fee revenue across the industry would become “plausible.”

There would also be repercussions among investors, who would wind up paying their managers fees for lower returns. The result, he said, would be for investors to “rationally allocate less to active funds and more to index funds,” dealing another potential blow to active managers’ revenues as they see lower assets under management.

“If greater skill spells less revenue, an upward trend in skill represents a potential challenge for the active management industry,” Stambaugh said. “Of course an industry of competing active managers cannot decide to calm that headwind by becoming less skilled. Applying more skill is in each manager’s individual interest.”

While having broad distribution of greater investment skill across the asset management industry would hurt its profitability, it would also produce more efficient markets. In the end, Stambaugh contended, it would be better for society at large.

“Greater skill produces stronger price correction in stocks,” he said. “Greater skill produces stronger price correction in stocks.”

 

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