The latest thinking from Greenspring Advisors.

Active Management ALWAYS Underperforms

J. Patrick Collins Jr., CFP®, EA

Active asset management is the strategy of picking a small number of holdings with the goal of outperforming the broad index.  For example, an active manager may invest in small US companies and pick 40 of those companies to include in his portfolio with the hope of outperforming the actual 2,000 small US companies in existence.  Most people believe that with enough hard work and intelligence this is very possible, especially in areas where there is less competition (like small companies, emerging market stocks or high yield bonds).  But there is a simple truth that the active managers won't tell you.  The average active manager in any asset class will always underperform his/her benchmark.  It is simple math that Nobel prize winner Bill Sharpe wrote in his brilliant paper, The Arithmetic of Active Management:

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

Think of it this way.  The ownership of an entire asset class is made up of the combination of passive investors (those that buy and hold the entire asset class) and active investors (those that pick and choose the funds they want to own inside that asset class).  If the passive investors own the asset class (some portion of it), the remaining active investors MUST own that same asset class if you look at them in the aggregate.  Therefore, if one investor overweights Walmart in their portfolio, some other investor must be underweighting it.  It is impossible for everyone to overweight or underweight a stock since someone has to own it.  In the same vein, when an active manager buys a stock (and profits from it) someone has to have sold it to him (and therefore lost out).  Trading is a zero sum game amongst active managers.

Notice, I have not said that all active managers will underperform.  It is the average of all active managers that will always underperform because of their fees.  There will be winners and there will be losers, but the average active manager will always do worse than his/her benchmark (FYI- this plays out perfectly in the data).  This is true over any time period:  one day, one month, one year, or 100 years.  So, if you believe in this simple math equation, you need to ask yourself one more question- can I pick a manager (or be one myself) that will be in the minority camp of active managers that outperform?  We'll save that topic for a future post.