Report: Active Management Will Always Have a Place in 'Mostly Efficient' Markets

A newly released report -- furthering the debate between active and passive management -- concludes that while finding superior active managers is not easy or simple, it can be done.

(December 20, 2011) — A new academic paper providing further fuel to the active versus passive management debate asserts that investors who can identify superior active managers (SAM) should be able to improve their overall Sharpe ratio by including a meaningful exposure to active strategies.

“Most debates have a clear winner: Lincoln beat Douglas, Kennedy beat Nixon, and Reagan beat Mondale. But the debate surrounding active versus passive management continues to rage after more than 40 years of contention,” asserts Robert Jones of Arwen Advisors and Russ Wermers of University of Maryland’s Robert H. Smith School of Business in their paper titled “Active Management in Mostly Efficient Markets.”

In response to why active management is here to stay even though, according to many academic studies, the average active manager doesn’t add value, Jones told aiCIO: “Its the combined activity of all these active managers that keep markets efficient and thereby hard to beat, and efficient markets mean better capital allocation, and thus greater growth and wealth for society as a whole. To reap this huge benefit, markets must encourage active management, which they do by heaping huge rewards on SAMs. Our paper also highlights that it may be possible for fund investors to identify SAMs in advance based on various metrics and characteristics.”

According to the authors, the research paper aims to answer the following three questions:

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1. Does active management add value?

2. Can we identify superior active managers ex ante?

3. How much active risk should investors include in their portfolios?

The paper concludes: “If we assume that the aggregate of all actively managed funds is equal to the market—that is, active management is a zero-sum game—then the aggregate of active fund returns equals the market return but incurs trading costs and charges fees, and so the aggregate will underperform the market by an amount equal to fees and expenses. Empirical studies seem to broadly support this conclusion…Active management will always have a place in ‘mostly efficient’ markets. Hence, investors who can identify SAMs should always expect to earn a relative return advantage. Further, this alpha can have a substantial impact on returns with only a modest impact on total portfolio risk. Finding such managers is not easy or simple—it requires going well beyond assessing past returns—but academic studies indicate that it can be done.”

The report jibes with recent remarks by Sam Kunz, head of the Chicago Policeman’s Annuity and Benefit Plan, who spoke with aiCIO earlier this year about international pension differences, mushroom hunting, and overconfidence. “In Switzerland, mushroom hunting is very popular. In the fall, there is a high probability there will be mushrooms when the sun is shining just after rain. But perfect conditions don’t guarantee you will be successful in finding any. The same holds true for active management,” he said. “At any given point of time, there are inefficiencies somewhere available to someone, but it doesn’t mean that investors are able to capitalize on them. In other words, markets might not be efficient, but the trick is to be able to take advantage of that inefficiency despite its versatility. Therefore, the budget for active management should be spent very wisely because our ability to consistently capture these opportunities is low.”

Giving light to the opposite side of the debate, research released earlier this year — carried out by students at Uppsala University — showed that if the stock market is on the upswing, then a passive management approach across a broader market index may be superior to an active approach. The study revealed that during periods when the stock market was on an upswing, actively-managed funds faced difficulty outperforming the index. However, during falling stock markets, actively-managed funds were more likely to outperform the index.

Undoubtedly, the active versus passive debate has been a popular topic within the institutional investor world. Mirroring the Stolkholm-based study, Lee Partridge, San Diego County Employees Retirement Association’s (SDCERA) outsourced portfolio strategist and CIO at Salient Partners, offered a skeptical tone. “We think that it’s important to get all the different strategies represented in a well-diversified portfolio…but are you really trying to bring in the return premium that comes from those strategies, or do you think the manager has skill over and above the strategy?,” he told aiCIO. “We think that both can be operable, but we’re fairly skeptical about skill. We think that skill really has to be proven and it’s very difficult to detect.”

Lou Moret, an outgoing CalPERS board member, has criticized the pension for investment earnings at the fund being below the median among institutional investors, as detailed in a quarterly earnings report by Wilshire.

(December 19, 2011) — During the last decade, investment earnings at the largest public pension fund in the United States have been below the median among institutional investors.

In response to Wilshire’s quarterly earnings report showing below-median earnings by the California Public Employees’ Retirement System (CalPERS), the fund’s outgoing board member, Lou Moret, told CalPensions.com: “We are glossing over this, and it looks horrible.”

According to the news site, the outgoing board member stated that during his previous roles on the Los Angeles Fire and Police Pensions, money managers with earnings below the median for up to four quarters were dismissed.

“The California Public Employees’ Retirement System generated a total fund return of -7.0%, for the quarter ended September 30, 2011,” Wilshire’s analysis stated. “CalPERS’ Total Fund generated a return of -7.0% during the second quarter, modestly outperforming relative to its strategic policy benchmark, which returned -7.16%. Per Wilshire’s attribution, the System’s lower-than-target allocation to income (18.2% actual vs. 19.0% policy) and real assets (9.0% actual vs. 10.0% policy) were the largest detractors, given that these were the two major asset classes that posted gains during the challenging third quarter. On the active management side, good relative performance by the growth asset class…was the System’s main contributor.”

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According to Wilshire’s report, CalPERS earnings during the last 10 years stand at 5.4% — a percentage that is slightly below the Wilshire median for large funds (5.7%) and lower than a broader Wilshire median for institutional investors (5.5%).

Earlier this month, a Stanford University-based economic think tank asserted that California’s public employee pension plans are facing long-term shortfalls as high as $500 billion. According to economist and former state Assemblyman Joe Nation, the report’s author, the shortfalls cost the state $3.4 million for each day that lawmakers fail to change the pension benefits and contribution levels for public employees.

Among the report’s findings for CalPERS, the California State Teachers’ Retirement System (CalSTRS), and the University of California Retirement Plan: “Using a ‘risk-free’ or low-risk discount rate — a method that is debated when experts talk about figuring out a pension system’s obligations — the total unfunded liability for CalPERS, CalSTRS, and the UC system is $498 billion. That’s up 17 percent higher than the $425 billion shortfall Stanford estimated in April 2010.”

CalPERS, however, claimed the study was an exaggeration.

“The study is written from a perspective that is intended to exaggerate perceived costs and the instability of pension systems,” said Ann Boynton, Deputy Executive Officer of CalPERS Benefit Programs Policy and Planning, in a statement released on the fund’s website. “The report’s findings were based on low discount rates to artificially magnify unfunded liabilities. It is important to remember that CalPERS invests in a highly diversified portfolio that includes stocks, real estate, and other assets that have historically earned significantly higher returns than the rates assumed in the study.”

Related article: Is the focus—and sometimes obsession—on assets under management when judging and predicting performance often erroneous thinking, reflective of a lack of logic? Many consultants think so.