Do Active Fund Managers Add Value?

Active fund managers have been around for years, with financial advisors frequently recommending them to less savvy clients. However, in recent years passive funds have been developed, and a wide swath of research by finance professors claims that active fund managers, as a group, do not beat the market.

This article will list a few arguments for and against active fund managers, along with describing a few finds from modern investment research.
Arguments In Support of Active Fund Managers

- According to Investment Week, recent M & G analysis shows that the top 10 active funds in the IMA UK All Companies hugely outperformed the FTSE All-share index, returning 117.7% on average compared with just 26.9% from the index.

- In emerging markets, the majority of the risk comes from geopolitical risk. Active fund managers will be able to use their skills to move assets away from troubled countries.

- Small and Medium cap companies, as well as those from emerging market economies, receive less attention from analysts. It is there before possible for skilled professionals to identify and profit from inefficiencies in these markets.

Arguments Against The Use of Active Fund Managers

- While some active fund managers have historically beaten the market, this is due to luck. As a group, empirical evidence shows that active fund managers underperform tracker funds, mainly due to the high fees that they charge. Just because a manager has outperformed the market in the past, does not mean that they will outperform the market in the future.

- The fees from active fund managers are too high, and seriously hinder their changes of outperforming the market. Investors are there before better off using tracker funds.

- A lot of the reported outperformance certain active investment styles can be attributed to passive factors that can easily be reproduced in a low cost, transparent and efficient fashion. The book "Active Beta Indications" provides a good discussion on this subject.
Other points of interest

The study - "Does Active Management Add Value The Brazilian Mutual Fund Market" - concludes that active management adds value for investors in stocks and hedge funds, but fails to do so in fixed income mutual funds. Brazil is categorized as an emerging market, so this finding goes in line with the argument that active management is more suitable for emerging markets, as well as small and medium cap companies.

Along a similar line of argument, some analysts have stated that well covered markets such as the US and UK large cap markets will be efficient due to the number of people trading them, but that opportunities could have been found in less covered areas. According to this line of thought, investors who wish to invest in large cap shares should invest in trackers, while those who wish to invest in smaller companies should choose actively managed funds.

Some large firms such as Merril Lynch and Goldman Sachs have conducted research to passively replicating the returns of active hedge funds. These use methods such as "factor-based replication" and "payoff distribution replication", and can involve regressing hedge fund returns against factors such as the VIX volatility index and interest rate differentials.

There Is No Firm Answer

The debate between Active and Passive fund management is still alive and strong. Two of the largest unanswered questions in this debate are:

- Do different markets have different levels of efficiency? The early arguments in favor of passive funds that asserted fund managers fail to beat the market. But more recently, proponents of active management have stated that it is developed markets that are efficient, and that those with skill can still beat undeveloped markets.

- Can the returns from active funds be passively replicated? The studies from Merril Lynch and Goldman Sachs are publicly available for those who wish to peruse them, and in the coming years there will undoubtedly be new investable funds based on these criteria.

In my personal experience, the equity indices are developed markets certainly contain areas of inefficiency, as I have managed to earn a living through speculating on the largest European equity index futures. However, what I do involves trading exceptionally short time frames, is non scalable, and therefore can not be applied to the mass market. From this I believe that there could be small areas of inefficiency in any market.

Conclusion

There is no firm answer as to whether or not active managers outperform the market. There are papers that claim to show empirical evidence both for and against them. And even papers based on empirical evidence can be questioned, as statistics can be fiddled to support the author's objectives.

An example of statistical curve fitting is the M & G analysis mentioned above. Based on a large sample of fund managers, we would expect them to roughly track the market (minus their fees). After 10 years, roughly half would beat the market, and roughly half would underperform. The number of fund managers that we'd expect to outperform the market would be a function of volatility, which would depend on the tracking error that active fund managers are permitted in their mandates.