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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a former global head of asset allocation at a fund manager
“After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” This was William Sharpe, the Nobel-winning economist, back in 1991 when index-investing was a decidedly niche pursuit. “The proof”, he added with a flourish, “is embarrassingly simple.”
What Sharpe termed “the arithmetic of active management” has become accepted truth among the financial cognoscenti. The trouble is, it’s been wrong. Such heresy needs qualifying. Damning data in support of Sharpe’s proof appears abundant. Morningstar, the financial data firm, publishes semi-annual active-passive barometers tracking more than 8,000 US funds and about 26,000 European-domiciled funds with assets of $17tn and €6.3tn respectively. In the decade to June 2023, only a quarter of US-based active strategies survived and beat passive alternates. In Europe, only 17 per cent of active equity managers and 23 per cent of active bond managers registered similar success.
Why have so many clients stuck with a more expensive and clearly inferior product? True, passive has grown substantially in size and now accounts for 39 per cent of the $41.5tn global funds market and 23 per cent of the $98tn total industry assets under management. But this just deepens the puzzle. The most sophisticated large clients appear to be those most eager to pay vast sums for active. One reason for this willingness to employ active managers is private markets. For those lacking the scale to run an in-house team, access requires external management. A second, more surprising, reason so much money has stuck with active management is performance.
In 2010, Dr Alex Beath left theoretical physics to join CEM Benchmarking. The Canadian firm works for $15tn of pension funds, sovereign wealth funds, etc, collecting cost and return data for their portfolios. They provide an unvarnished picture as to how well or terribly their clients’ managers have performed. The data has the advantage of being actual, rather than representative; close to real time; and devoid of survivorship bias. Clients are precisely the large institutions that should know better than to allocate to an active manager.
“I joined the industry assuming active management was a con,” he tells me. In 2019, he authored a study for clients examining the returns to their actively managed large-cap US stocks using the firm’s data set. The chances of outperformance before costs, he found, was “no better than a coin flip”. After fees, the odds that half of portfolios would outperform the benchmark fell close to zero. The evidence around US large-cap equity portfolio management followed Sharpe’s simple logic almost to the basis point.
But it turns out that US large caps are exceptional. “No matter how hard I’d like to explain it away, managers outside of US large-cap stocks beat the market,” Beath told me, before adding a qualifier “perhaps not by as much as some would like to say.” A paper he co-authored in 2022 puts statistical meat on this bone. Analysing nearly 9,000 observations from 1992-2020, Beath found the average fund in the CEM database outperformed its benchmark by 0.67 percentage points gross of costs and 0.15 points net of costs per year. Investors with more actively managed portfolios did better. This related to public markets. The same study found that management fees more than destroyed the value-add from private equity and unlisted real estate.
On the other side of the Atlantic, a study by the UK’s Competition and Markets Authority arrived at similar results. Digging into the world of investment consultancy, they found that active managers that had been researched and assessed as “buy-rated” outperformed their benchmarks by 0.92 percentage points a year on average, before costs. They also found a randomly selected fund would outperform by 0.7 percentage points, gross of costs. While management costs to retail fundholders might devour such gains, for large institutional clients they tend to be more modest.
How to square the results? Markets are efficient, but not perfectly so. They appear too efficient to bear the weight of mutual fund fees, but insufficiently so to justify large investors’ use of active managers. The scale of value-add is small, but highly statistically significant.
Jack Bogle, founder of passive pioneer Vanguard, once described active managers as “the greedy parasite who eats away at the host”. It’s hard to argue with that assessment in aggregate when discussing mutual funds, private assets or indeed US large-cap stocks. But when working for large institutional investors, active managers have defied Sharpe’s proof.
