The Disadvantage of Passive Management

The Disadvantage of Passive Management

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The passive management industry has been doing an amazing job of projecting their mantra in to the investing zeitgeist, and every year we’re exposed to claims like “74% of active managers underperformed their index.” Like several good cons, this isn’t an false statement. It’s however, a great utilization of misdirection – making implications about passive strategies which are false.

“In the event that many active managers underperform, I suppose I’ll go passive.” This is actually the inference the passive industry seeks in the world, but yet one which the uncritical investor has get scammed by. This is not really a rejection of passive strategies, however a couple of ideas regarding how to more precisely think about the active versus. passive debate.

Let us begin with an apparent point. It might be the situation that 74% of active managers underperform their index inside a given year, what remains unsaid is when all passive managers do their finest to follow along with their investment policy, 100% of these will underperform! Why? Investment strategy returns could be reduced to some reasonably simple equation:

Strategy Return = Market Exposure Alpha – Charges

Therefore if your alpha is % (all passive strategies), as well as your charges are > $ (all companies), your returns are less than what pure market exposure would produce. 100% of passive strategies should underperform their indices. 74% is not great, but it is much better than 100%.

OVERSIMPLIFIED

Passive managers are very well conscious that active managers’ returns really are a product of the market exposure (Beta), as well as their skill (Alpha). The truth that the passive industry continues using the trick of evaluating all active managers to some non-risk-adjusted performance figure is deplorable, since it confuses most investors.

Most active managers run less dangerous portfolios than their index or benchmark. Asset management is risk management, and prudent risk reduction shouldn’t be penalized. When sophisticated investors compare managers, they compare risk-adjusted returns. The only method you should be figuring out an energetic manager’s value is as simple as calculating alpha generation.

ZERO SUM GAME

Alpha doesn’t appear in nature. If alpha is produced in a single manager’s portfolio, it always implies that another manager has produced negative alpha. Picking the manager that may generate lengthy-term alpha is not an insignificant exercise, but it’s certainly well worth the effort thinking about the outcome that the strength of compounding over decades has. Even when there’s no alpha typically, there are lots of managers who generate it.

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