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Takeaways:
At the core of the active-passive debate is the question of whether active equity managers are skilled enough to cover costs. A large number of studies show the average fund underperforming a passively managed portfolio, revealing that stock-picking skill is on average insufficient to offset fees.
- Active equity fund performance depends on the stock picking skill of the investment team as well as current market conditions.
- Recent academic research confirms that returns to stock picking skill rises in tandem with increased stock return cross-sectional dispersion and skewness, along with greater market volatility.
- Active equity opportunity (AEO) is estimated using these measures to show how active the emotional crowds are at driving stock return dispersion.
- Returns-to-skill is strongly influenced by the current market environment as captured by Active Equity Opportunity.
- The impact of AEO on stock picking is largely independent of where we are in the business cycle.
- Returns-to-skill varies positively with the degree to which a fund is truly active, as measured by conviction, tracking error and size of assets under management.
- It may be beneficial to allocate more to stock picking funds and less to market exposure funds as AEO rises.
- When AEO is low, it still does not make sense to invest in closet indexers, since, while they outperform their truly active counterparts, their average alpha remains negative.
On the other hand, many studies demonstrate truly active funds, as contrasted to closet indexers, do outperform. Truly active funds are those with high active share, low R-squared with respect to the fund’s benchmark, smaller AUM (generally less than $1 billion), strategy consistency and large positions in best-idea stocks, among other identified fund characteristics. Unfortunately, distribution incentives strongly encourage funds to grow excessively large and become closet indexers, leading to the average industry underperformance, as closet indexers far outnumber truly active funds.
In recent years, however, many truly active funds have underperformed as well. This begs the question of whether the returns to stock-picking skill varies over time. Indeed, there is considerable anecdotal evidence that stock picking is effective in certain market environments and not in others....
I'll stop here to make a quick point. The author of this piece, C. Thomas Howard, holds a BS in mechanical engineering from the University of Idaho, an MS in management science from Oregon State University, and a PhD in finance from the University of Washington.
He's a Professor Emeritus at the University of Denver.
And he should have met grandmother.
She advised the young people that nine times out of ten when you say 'begs the question' you actually mean raises the question and her opinion of you would decline with each misuse.
And if you used decimate to mean anything other than 10%, well you might as well just start slinking away. She was a sharp-tongued woman and not shy about pointing out when someone was wrong on the pre-internet.
