Can Active Managers Beat the Market?

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How easy is it to beat the market? Even for skilled money managers, it is not easy.

There has been considerable debate around the advantage of actively managed mutual funds over other options such as index funds, exchange-traded funds (ETFs) and other passively managed funds. Are actively managed mutual funds worth the accompanying fees to earn a larger return? Even if a fund outperforms the market, how much of the return is attributable to skill versus luck?

The conventional wisdom follows Carhart’s 1997 assertion that “the results do not support the existence of skilled or informed mutual fund portfolio managers.”

However, a recent article by Martijn Cremers, Jon Fulkerson, and Tim Riley, “Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds,” challenges this conventional wisdom. The authors conducted a comprehensive review of the literature since Carhart, focusing on U.S. equity mutual funds. They found several instances where studies challenged the conventional wisdom as well as highlighted limitations of the current literature.

Conventional Wisdom

The invention of the first passive investments in the late 1970s revolutionized investing. The first index mutual fund, invented by Jack Bogle , allowed investors to approximately replicate market performance at a fraction of the cost of traditional mutual funds. As index funds became more popular, other passive options such as exchange-traded funds emerged. ETFs still track indexes with low costs and fees, but they are able to be traded throughout the day like stocks. Many 401(k)s have started allowing the purchase of ETFs, and some predict the number of ETF assets in retirement accounts could overtake mutual fund assets by 2024.

Passive investment strategies have been praised for individual and professional investors alike due to their low fees. Warren Buffett, in the 2016 Berkshire Hathaway annual shareholder letter, stated, "My regular recommendation has been a low-cost S&P 500 index fund." During times of economic growth, this makes perfect sense. Why pay extra fees for an actively managed fund when passive options perform just as well?

Academic literature has traditionally agreed. The fees from actively managed funds offset—or more than offset—the value provided by managers. The conventional wisdom discussed by the researchers centers on three findings:

1. The average fund underperforms after fees.
2. The performance of the best funds does not continue over time.
3. While some fund managers are skilled, few have enough skill in excess of costs.

The authors conclude that, “overall, [the] review of the literature suggests that the conventional wisdom judges active management too negatively.” Instead, they say “the conventional wisdom fails to account for the positive findings of recent research on active manager skill.”

Challenging the Conventional Wisdom

Much of the literature in the past 20 years challenges the conventional wisdom on active management. How should we measure manager skill? What is the proper way to measure fund performance? What are limitations or constraints regarding how we value active management? These are questions asked by the authors as they attempt to determine whether active management is worth the accompanying fees.

Manager Skill | A substantial amount of research applying new measures, new methods and new data show that managers’ skills create real value for investors over time. Literature commonly equates skill with the ability to generate alpha—the excess return of an investment net of fees over a benchmark. The benchmark chosen and the quality of data significantly impact the calculation of the net alpha of the fund and therefore manager skill. Due to the reverse survivorship bias, studies found that “using the average alpha across all funds as a measure of average skill understates the true average skill.” The authors discuss an alternative measure of skill proposed by Berk and van Binsbergen in 2015 that measures skill as the fund’s gross return in excess of its benchmark multiplied by assets under management. This reflects the idea that the net alpha is “determined in equilibrium by competition between investors, and not by the skill of managers.”

Active managers use various skills to help them create value for investors. Research found a manager’s ability to pick stocks, predict future market direction, manage information, influence corporate oversight, manage taxes and maintain a disciplined investment approach helps them create value. Personal history has also been found to predict performance. One study found that “managers born into poor families tend to outperform managers born into rich families.” Another study found the quality of a manager’s MBA program to be related to future performance.

Fund Performance | Actively managed funds are compared to a passive benchmark of equivalent risk to determine the value they create. Choosing the benchmark becomes, then, extremely important. The SEC requires every mutual fund to disclose a benchmark index, but research has shown these self-declared benchmarks often do not accurately represent the investment style of the fund. They also rarely change—even if the fund managers change their style over time—and often have less risk than the funds themselves. The authors suggest alternative methods of determining a benchmark which can be used to measure performance more accurately, such as the “minimum active share” benchmark.

Despite the phrase, “past performance is no guarantee of future results,” investors invest more in the funds with the best past performance. Research has found that investors “estimate a fund’s performance by adjusting only for risk relative to the overall market.” They also use the benchmark required by the SEC when making investment decisions even if it does not represent the investment style of the fund. This approach is easier for investors, which may explain its popularity. This investor behavior supports the need for an accurate benchmark to measure fund performance.

What About Now?

If there ever was a time for active management, now might be it. Volatility is high due to uncertainty surrounding the COVID-19 pandemic. While passively managed funds obviously perform well during a bull market, are the extra costs of actively managed funds worth it during times of uncertainty?

Many traditional models have understated the value of active management during recessions—ignoring the impact of market conditions—and, in turn, making managers appear less skilled than they are. In recessionary periods, active management resulted in positive risk-adjusted returns, while the same funds resulted in negative risk-adjusted returns in growth periods.

The question remains whether active management will work as well in 2020 as it did during the dot-com bubble, when active investors capitalized on market mispricing. Likewise, if a global economic downturn affects many segments of the market, investors will have to decide if active management offers any benefits.

COVID-19 has caused major change in the United States and around the world. As investors become more uncertain, they will wonder where—and how—to invest their money. Conventional wisdom has long suggested that actively managed funds are not worth the high accompanying fees. But the authors’ assertion that “active managers have a variety of skills and, in many cases, tend to make value-added decisions…even after accounting for fees” complicates this conventional wisdom.

Before you automatically accept the conventional wisdom, consider the benefits skilled fund managers offer during uncertain economic climates. It may not be easy to beat the market, but skilled managers have a better chance at succeeding than most.