Active vs Passive Portfolio Management

Notwithstanding all the warnings about why active portfolio management is not the way to go, it remains a fact that investors prefer active management to passive management of their wealth. When you think about it, it makes a lot of sense. We as human beings seem to believe that doing something is always better than doing nothing, so that even when it will be to investors’ detriment at least 90% of the time to go with active wealth management, they feel more at ease with that choice. Of all the warnings about why we should always prefer passive management, one of the most repeated is that active managers simply do not outperform the market, and certainly not on a consistent basis. In fact, active managers underperform the market and passively managed portfolios-when cost is taken into account. Studies have shown that only 1% of passive portfolio managers have the skill to make alpha returns- excess returns a portfolio earns as a result of the manager’s skill. All this is to say that going with the odds, most people should stick with passive managers since they have a 99% chance of picking an active manager who either performs just as well or worse than a passive manager. The bonuses of the big bankers however, points to the fact that there is in fact money to be made. What their ginormous bonuses also point to is that most of the available profits is being swallowed by the fees (incentive and management fees) paid to fund managers. Some measures such as hurdle rates and high water marks have been put in place to ensure fairness, but those measures are simply not enough.

Apart from the management and incentive fees, investors also have to pay loads (both back and front in some cases) and bear the cost of the frequent trading which as it turns out is very expensive. It is hardly the case that investors actually know how much they are coughing up in all kinds of fees as the fees are usually split up. A necessary step to protect investors will be for regulatory bodies to necessitate providing an accurate picture of how much investors will be paying in fees by aggregating the costs. One dollar here, fifty cents there soon adds up to $100 and then $1,000.

Studies show that returns are really a game of chance. To summarize it very inadequately, a popular study in the field of finance by De Bondt and Thaler (1985) showed how portfolios that had excess returns over a 36 month period (termed “winners”) tended to lose in the next 36 month period and those termed losers tended to win in the next 36 month period making it a zero sum game. The study points to the fact that due to wide availability of information, it is difficult and close to impossible to beat the market. The outperformance many managers boast of is mostly as a result of chance and will tend to be inconsistent. But even when fund managers do beat the market, the cost of trading renders their big win moot. Studies about reversion to the mean also show how individual stocks cannot consistently outperform their fundamentals. Picking winning stocks is just as chancy as picking a truly skilled portfolio manager. Keep that in mind before you decide to entrust your life savings to one.