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Passive vs. Active Management

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The question of whether to invest in actively or passively managed mutual funds is an important one.  Both theoretical arguments suggests that passive management (e.g., investing in index mutual funds) is usually prudent.

William F. Sharpe, "The Arithmetic of Active Management," Financial Analysts Journal, JanuaryFebruary 1991, pp. 7-9. "If 'active' and 'passive' management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.  These assertions will hold for any time period."  This brief, lucidly written article is perhaps the simplest and most persuasive theoretical case ever made for passive management.  Written by a Nobel Prize winner.

Anna Bernasek, "The Man Your Fund Manager Hates," Fortune, December 1999. An interview with Burton Malkiel, author of A Random Walk Down Wall Street: The Best Investment Advice for the New Century.

John C. Bogle, "Selecting Equity Mutual Funds: Why is it virtually impossible to pick the winners, yet so easy to pick a winner?  And what should you do about it in the 1990s?," Journal of Portfolio Management, Winter 1992, pp. 94-100. "Picking the winning fund is virtually impossible, because reliance on past performance is of no apparent help."  "Picking a winning fund is made easy by selecting a passive all-market index fund, or perhaps by engaging in thorough research and careful analysis."  "... intelligent investors simply cannot disregard the heavy burden of costs endemic to most actively managed funds, and clearly should consider index funds for at least a core portion of their equity holdings."

John C. Bogle, "Equity Fund Selection: The Needle or the Haystack?," a speech presented before the Philadelphia Chapter of the American Association of Individual Investors, November 23 1999.

John C. Bogle, "Three Challenges of Investing: Active Management, Market Efficiency, and Selecting Managers," a speech given in Boston on October 21 2001.

David G. Booth, "Index and Enhanced Index Funds," Dimensional Fund Advisors, April 2001. "In summary, logic and empirical evidence overwhelmingly favor an investment approach based on index funds. The returns are higher and the fees are lower. The returns of an asset class are assured. The discipline keeps the portfolio fully invested, thereby avoiding the adverse timing pitfall inherent in investment committees and active managers."

Eric Brandhorst, "Problems with Manager Universe Data," State Street Global Advisors, November 22 2002. This article debunks the often repeated notion that active managers tend to beat passively managed portfolios in small and international asset classes.  "Even the two asset classes (international equity and U.S. small cap) that are often held up as examples of arenas where active managers can consistently add value lose their active management luster when appropriate adjustments are made to the median manager data."

Anthony W. Brown, "Why Indexing Makes Sense," Hammond Associates, June 1999. An excellent layperson's discussion of why passive management makes sense.

Warren E. Buffet, "How to Minimize Investment Returns," Berkshire Hathaway 2005 Annual Report, 2005. An extremely brief, tongue-in-cheek look at the active vs. passive management issue, indirectly by focusing on fees charged by investing middle men.  Also see the similar Sharpe 1976 below.

Scott Burns, "Major Index Funds are Superior, not 'Average'," Dallas Morning News, September 21 2004.  Also here.

John M.R. Chalmers, Roger M. Edelen, and Gregory B. Kadlec, "Fund Returns and Trading Expenses," Working Paper, August 30 2001 (183kb). "We find a strong negative relation between fund returns and trading expenses.  In fact, we cannot reject the hypothesis that every dollar spent on trading expenses results in a dollar for dollar reduction in fund value."  "... our evidence suggests that fund managers fail to recover any of their trading expenses [i.e., trading does not increase returns]."  "In this paper, we reject the hypothesis that active fund management enhances performance."  This paper supports a passive investing strategy.

Charles Duhigg, "Fund Fees Complicate the Manager-vs.-Index Equation," Washington Post, July 6 2003, p. F04. A very basic article discussing the passive vs. active issue at a high level.

Edwin J. Elton, Martin J. Gruber, Sanjiv Das, and Matthew Hlavka, "Efficiency with Costly Information: A Reinterpretation of Evidence from Managed Portfolios," Review of Financial Studies, 6(1) 1993, pp. 1-22 (260kb). "Mutual Fund managers underperform passive portfolios.  Furthermore, funds with higher fees and turnover underperform those with lower fees and turnover."

Richard M. Ennis and Michael D. Sebastian, "The Small -Cap Alpha Myth," Journal of Portfolio Management, Spring 2002, pp. 11-16 (180kb).  This paper debunks the popular perception that it is beneficial to use active management in small-cap stocks.

Eugene F. Fama and Kenneth R. French, "Luck versus Skill in the Cross-Section of Mutual Fund Returns," Journal of Finance, Forthcoming (363kb). This paper uses an approach similar to that used in the Murphy paper below, only using more real-world data.  This paper takes real data of mutual fund performance (i.e., which shows a range of estimated alphas) and deliberately adjusts each fund's performance data set so that its alpha is zero (i.e., its estimated alpha is subtracted from each data point).  Thus, each synthetic fund now has a known alpha exactly equal to zero.  This data base of synthetic zero alpha funds was then used to generate 10,000 monthly returns using a bootstrap sampling approach (with replacement).  These monthly returns yielded an example of what might be expected in real life if it were true that the true alphas of each fund were, in fact, exactly equal to zero.  The paper found that the distribution of realized alphas from the simulation (i.e., where it was known that the true alpha was zero -- that any resulting apparent alpha was merely due to good luck) was similar to that found for actual funds.  In fact, if anything, the distribution of alpha estimates for real funds showed that the actual alpha of real funds was probably negative, but no better than approximately zero.  Thus, good alpha estimates for real funds were consistent with what would be expected through luck alone (i.e., suggesting that good results of actively managed funds are due to good luck and not skill).

Eugene F. Fama and Kenneth R. French, "Luck versus Skill in Mutual Fund Performance," FamaFrench Forum, November 30, 2009. This is a slightly less technical description of the above FamaFrench paper.  The paper uses a simulation to show that the actual alphas of actively managed funds are no better than, and probably worse than, those expected purely through good luck alone (i.e., worse than they would be through simulations with alphas pre-programmed to be exactly zero).  This suggests that apparently good performance of actively managed funds is generally consistent with what would be expected through luck alone (i.e., good performance should generally be attributed to good luck and not to skill).  However, this is not evident from merely evaluating an active manager's performance, even if it is adjusted for risk (e.g., a calculated "alpha").

Thomas P. McGuigan, "The Difficulty of Selecting Superior Mutual Fund Performance," The Journal of Financial Planning, February 2006, pp. 50-56. An interesting study.  They conclude that the overwhelming majority of actively managed funds underperform passive alternatives.  While they concede that there have been a very small minority of actively managed funds which have consistently outperformed passive alternatives, it is "difficult" to identify them in advance.

Ross M. Miller, "Measuring the True Cost of Active Management by Mutual Funds," SUNY Albany, June 2005 (150kb). This interesting paper derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management.  Computing this “active expense ratio” requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by Morningstar was 7%, over six times their published expense ratio of 1.15%.  More broadly, funds in the Morningstar universe had a mean active expense ratio of 5.2%, while the largest funds averaged a percent or two less.

William F. Sharpe, "The Parable of the Money Managers," Financial Analysts Journal, JulyAugust 1976, p. 4. An extremely brief, tongue-in-cheek look at active vs. passive management.  Written by a Nobel Prize winner.

William F. Sharpe, "Indexed Investing: A Prosaic Way to Beat the Average Investor," a speech presented at the Spring President's Forum, Monterey Institute of International Studies, May 1 2002. Written by a Nobel Prize winner.

Rex A. Sinquefield, "Active vs. Passive Management," Dimensional Fund Advisors, October 1995. A speech given during a debate on the merits of active vs. passive management.

Steven R. Thorley, "The Inefficient Markets Argument for Passive Investing," Brigham Young University, September 1999. This paper argues that passive investing is indicated even if you assume that markets are inefficient and that stock-picking can successfully "beat the market."

Steven R. Thorley, "Beating the Odds: Active vs. Passive Investing," Marriott Alumni Magazine, Summer 2002. An excellent, very readable discussion of the issue.

Russ Wermers, "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses," Journal of Finance, Vol LV No. 4 August 2000, pp. 1655-1695 (182kb). This paper concludes that the stocks held by active mutual funds exceeded the market index by 1.3% per year, but that those same funds underperform the same market index by 1% per year after fund costs and "cash-drag" are accounted for.  The bottom line is that this paper's data suggests that it is beneficial to invest in a market index fund (NOT an actively managed fund) as long as that fund's costs and "cash drag" are less than 1% per year.  This hurdle is easily cleared by, for example, the Vanguard Total Stock Market Index Fund (VTSMX), whose costs and cash drag appear to be less than 0.2% per year.  In other words, the average active equity fund investment dollar could have annual returns of about 0.8 percentage points higher simply by investing in a good market index fund.

Jason Zweig, "I don't know, I don't care," CNNmoney, August 29, 2001. The benefits of passive investing.

"Myths and Misconceptions about Indexing," Vanguard, July 2003.

"The Case for Indexing," Vanguard, September 2003.

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