EXECUTIVE SUMMARY
• Strong theoretical arguments and extensive empirical data support the view that we should expect most active managers to underperform most of the time. But most of the time is not all of the time, and most active managers are not all active managers. So it is reasonable to ask whether active performance tends to wax and wane.
• We examined fund performance in various market environments to see whether certain conditions correlate with better active performance. We found that active managers were particularly challenged in periods when dispersion was low, stock prices rose, and market leadership came from extremely large stocks.
• Active managers seemed to perform less poorly in years when the low volatility factor underperformed. This suggests that managers, as a group, have a tilt against low volatility stocks.
INTRODUCTION: PASSIVE VERSUS ACTIVE
The debate between passive and active investing has a long history, but in recent years it has escalated to the forefront of investor awareness. A summary of the arguments advanced by the advocates of passive investing would include the following.
• Alfred Cowles’ (1932) paper on the unimpressive predictive power of stock market forecasters1
• William Sharpe’s introduction of the Capital Asset Pricing Model (1964)2 and Eugene Fama’s random walk hypothesis (1965),3 providing a theoretical underpinning for owning the market portfolio rather than relying on active stock selection
• Pleas from Burton Malkiel (1973)4 and Paul Samuelson (1974)5 that someone (anyone!) launch a prototype capitalization-weighted index fund
• Charles Ellis’ (1975) argument that the professionalization of the investment management business made consistent outperformance unlikely6
• Sharpe’s (1991) simple demonstration that “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” 7
In addition, numerous observers, prominently including our own firm, have followed in Cowles’ footsteps in accumulating empirical data on the performance of active managers.8 The results confirm what theory predicts: most active managers underperform most of the time.
However, while active managers as a group cannot outperform, there is no theology to say that individual managers cannot outperform, or do so consistently.9 Even if we expect that more than half of active managers will typically underperform, theory does not tell us whether the underperformers will be 51% or 91% of the total. It is reasonable to ask if there are some market conditions that are conducive to relatively favorable (or, more precisely, relatively less unfavorable) active results.
