The paradox of active and passive mutual funds

K@W has an interesting note on this paradox.  

The paradox is if passive funds give better net returns (gross returns minus fees) why do active funds remain? And not just remain but active funds are more popular as well. There have been number of reasons for the same:

Investors are duped by slick managed-fund marketing, they don’t know the facts or they believe “you get what you pay for” — that paying higher active-management fees should buy better results. Maybe they are deferential to “professionals,” or believe they are smart enough to pick the active managers who are better than average. All those explanations have one thing in common: They assume investors are not very bright.

The note points to a new paper –  On the Size of the Active Management Industry written by Robert Stambaugh and Lubos Pastor. In this the authors take a different take.

They instead assume investors as rational and not the irrational/not bright explanation given by others.

The authors say that as industry becomes competitive and offers decreasing returns, investors look for fund managers who can give them higher alpha.

For active managers, the Holy Grail is “alpha,” the industry’s term for a return that exceeds the market average when the investment’s risk is taken into account. There are two ways to conceive of alpha on an industry-wide basis, Stambaugh notes.

In the first view, alpha is a constant figure, a percentage by which active managers would beat or trail the market. If investors held this view, they would pull all their money out of actively managed funds as soon as they concluded that alpha was negative — that managers could not consistently match or beat the market. Stambaugh and Pastor studied active and passive fund returns from 1962 through 2006 in relation to the amount of money investors had committed to each type of strategy. Because active management trailed consistently, investors who viewed alpha as constant should have pulled all their money out of actively managed funds by 1969. But they didn’t.

In the second view, alpha is not constant. Instead, it depends on “industry size,” or the amount of investor money chasing bargains through active management. This, Pastor and Stambaugh believe, is the view that explains why investors remain committed to active management despite its poor track record. As a group, investors expected results for active management to improve when less money was committed to that investment strategy.

After a period of poor performance, the rational investor realizes that other investors will pull some of their money out of actively managed funds, making bargain finding easier. The investor will also pull only some of his own money out, because he wouldn’t want to miss the chance of improved results after others pull money out. “If some money is pulled out of the industry, that is going to allow more mispricing opportunities to exist,” Stambaugh says.

Interesting analysis. In the end he says:

Stambaugh says he does not dispute those who see other factors in investors’ embrace of active management — namely industry marketing, pressure from brokers and financial advisors, ignorance and so forth. But his work with Pastor, he adds, provides a simpler explanation for investor behavior: “There’s no reason to resort to calling investors stupid if you can explain [their behavior] without doing that.”

🙂 A perennial debate on fund management just like the state vs market debate.

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