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Active vs. Passive Management
by Jonathan Berk
Associate Professor, Haas School of Business
U.C. Berkeley
Guest Columnist for Grubman Financial Consulting
September 2005
Understanding how market forces shape our investment choices can be difficult. Too often, seemingly obvious insights turn out to be wrong. Take portfolio managers, for example. Because active managers advertise that they can generate excess returns while passive managers make no such claims, you might expect to do better investing with active managers rather than with passive managers. Yet as obvious as this logic seems, it is flawed. In a well functioning, competitive, capital market (like in the U.S.), investors should expect to make the same return from investing with active and passive managers who take on the same level of risk. Let's see why.
First, a little background. As most of us already know, there are two kinds of portfolio managers. Active managers claim either stock picking or market timing ability. They advertise that by employing their skills they can generate excess returns. Passive managers make no such claims. They merely offer diversification services by investing in hundreds of stocks. The benefit to investors of passive management is that by diversifying in this way they are able to substantially lower their risk exposure without having to pay the substantial transaction costs that would accrue were they to try to diversify by themselves.
If investors really expected active managers to deliver greater returns than passive managers nobody would want to invest with passive managers. Any investor in passive management could retain the same degree of diversification by costlessly moving his money to a large number of active managers (making sure not to pay any loads), thereby improving his returns. The inevitable result would be excess demand for active managers. As in any market, if there is excess demand for a product, its price must rise until this excess demand dries up. So the price of active management services must rise, that is, active managers will raise their fees, thereby reducing the return they provide to investors. They will raise their fees as high as they can get away with --- to the point that investors stop wanting to invest with them. That will happen when the expected return of active and passive managers who take on the same level of risk is the same.
At first glance this equilibrium might seem odd. If investors cannot expect to make excess returns with active managers, why invest with them at all? But consider what would happen to an investor who decided to move her money from active into passive management. Recall that because most mutual fund managers are paid as a percentage of funds under management, her action will reduce the amount of funds under management, thus reducing the manager's fees. Since prior to this fee reduction, the fund was expected to have the same return as a comparable passive fund, when the investor withdraws her fund the expected return of the fund must rise. Thus, our investor will actually regret this move --- she will want to move her money back to the active fund. Anticipating this, she will not choose to take her money out in the first place.
If investors expect to make the same return with active and passive managers, are active manager's skills wasted? No. By charging higher fees than their passive counterparts, active managers capture all the benefits of their skills. Picking stocks is a difficult thing to do. If it were easy, investors could avoid management fees altogether by just picking the stocks themselves. Just as your family doctor is compensated for his skills, so is your active money manager.
The insight that investors should expect active managers to earn the same expected return as passive managers is not always appreciated even by people who should know better. For example, every so often an editor of a reputable financial publication will have the bright idea of evaluating active managers by seeing if they can beat a simple strategy of picking stocks by throwing darts at the financial pages (sometimes the more creative ones have monkeys doing the stock picking). Invariably, the dart thrower does as well as the managers, inevitably leading the editor to the erroneous conclusion that the active managers have no more skill than a dart thrower (or a monkey, as the case may be). What these editors miss is that the dart thrower is not charging any fees. Were he to try, the fees would have to come out of his return, thereby leaving him lagging the active managers. Rather than conclude that active managers add no value, this "experiment" actually implies the opposite.
While recognizing that the expected return of the average active manager must equal his passive counterpart, you might wonder about the high skilled managers. Surely, they will be able to beat their passive counterparts, and hence it might make sense to try to ferret them out. This is another example of a seemingly obvious idea that is actually wrong and something I will address in my next column...
Jonathan Berk is an Associate Professor of Finance at the Haas School of Business, University of California, Berkeley. Readers who are interested in exploring the ideas in this column in greater depth can consult a paper published in the Spring 2005 issue of the Journal of Portfolio Management entitled "Five Myths of Active Portfolio Management".
