While I have heard this research referenced many times, usually by ETF and passive fund salesmen, I’ve met very few people who’ve actually read it. A body of work that has such a strong influence on investment strategies surely deserves greater understanding and scrutiny before being accepted as truth. With this in mind, I intend to review the major studies in this area and summarise their conclusions, and how they relate to the investible world faced by most people every day.
This is no small undertaking – there is an awful lot of ground to cover. To make things more manageable, I’m going to start with the theoretical papers, then look at the empirical research and finally see if I can apply these same conclusions based on the data available on UK funds.
First off, let’s get all the accusations of bias out in the open now, as they’ll inevitably end up in the comments section.
Firstly my biases – as an analyst I’ve focused mainly on active funds, but in my current role as a consultant I recommend both actives and passives. FE Trustnet draws the bulk of its revenue from advertising by fund groups. This includes both active and passive fund providers, but with a skew towards active providers in line with the UK market place.
FE, owner of Trustnet and my employer, provides numerous services to all parts of the industry, has the largest, most comprehensive database on mutual funds in the UK and is a leading provider of analysis and data – which naturally needs to be accurate and unbiased in order to be marketable.
While it won’t really feature in anything I refer to in this article, I also want to address the notion of survivorship bias, as undoubtedly that will crop up when I start looking at the data. Every fund that ever existed is included in the data for sector averages. We maintain a database of dead funds – a fund closing does not mean its results are excluded from our calculations.
OK, so with housekeeping out of the way, let’s start looking at some academics. The two theories most commonly used as a foundation for championing passive funds are the "zero sum of active management" and the "efficient market hypothesis". Despite not being the best known I’m going to look at the zero sum of active management this time and save the efficient market hypothesis for next time.
Zero-sum theory is a term I’ve coined to describe several works discussing the same idea but with wildly different terminology.
While I haven’t been able to trace the precise epidemiology of the theory, one of the better known proponents is William Sharpe, professor of finance at Stanford University, who won a Nobel Prize for his work on the capital asset pricing model and is the creator of the widely used Sharpe ratio.
In 1991, Sharpe published a paper in the Financial Analysts Journal titled The Arithmetic of Active Management – a paper that detailed the theory that if passive funds are just tracking the market, then active funds must be trading against each other.
Every successful decision to buy or sell a stock must have a counter party on the other side of that trade that lost out. For every manager successfully buying low and selling high, there must be an equally unsuccessful manager buying high and selling low. This ensures that in aggregate, active funds cannot possibly outperform the market.
This is summed up in the paper as the capital-weighted average return of the market being effectively the sum of all trades. Therefore as the fees on active management are higher than those on passive management, active funds must, as a matter of simple adding up, underperform passive funds across all time periods.
This paper is one of the more readable ones published in the field as it relies on fairly straightforward mathematics and can be found on the Stanford Business School’s website. It is also quite short and written in relatively plain language, so a good one to read if you want to understand the theory in more detail.
Sharpe explains a number of reasons why this theory is probably not true, in the US market at least. These are worth looking at as well.
First off the argument assumes that all active investors are active fund managers. However, this is not the case: there are a large number of private investors with little or minimal expertise in the market, and it is quite possible for active fund managers to take the opposite side of the trade to these amateurs and thereby beat the market.
Sharpe dismisses this effect as unlikely; which in the US equity market, where he conducts most of his research, may be true.
However, in other asset classes it could be a more reasonable assumption. In emerging markets where there is a bigger culture of stock market speculation as a form of gambling, this effect could have a genuine impact, something I’ll try and prove when I start on my own analysis.
Even within the UK the actively managed funds in the IMA UK All Companies sector account for just 6 per cent of the market capitalisation of the FTSE All Share Index. While my calculation was quite crude, it goes a long way to showing that active funds people can buy in the UK are a long way removed from the average active fund referred to in Sharpe’s paper.
Secondly, Sharpe acknowledges that one of the freedoms active managers have is to go off benchmark, and this can result in above-market returns. Sharpe dismisses this effect as having an equal chance of improving or detracting from performance depending on market conditions. If the notion that active funds can’t beat the market overall holds true, then this assumption will as well.
Sharpe also points out that another possible misleading factor in the data is that fund sector performance averages treat every fund equally rather than taking in to account the amount of money that is being run. Thus a few very large funds being run poorly may be providing outperformance opportunities for a large number of small funds, yet the sector performance treats all these equally, thus skewing the result in favour of the active funds.
This is an excellent observation and one that definitely requires further analysis. Within UK equity I wonder how many giant poorly run default pension funds are presenting opportunities to other active managers?
Finally there is the assumption that all passive funds return the market performance less fees. Most passive funds don’t track the market perfectly and have replication strategies that in some cases manage a fairly poor impression of market return.
While advocates of passives are likely to site funds from Vanguard or ETFs, the truth is that these are relatively recent entrants to the tracker market in the UK and that previous to that, the sector was populated by some very poor tracking funds. These undoubtedly still account for a large portion of the assets under management and also provide outperformance opportunities for the true active manager.
So, what does this particular piece of research tell us then? That market returns are the sum of all trades. That passive funds aren’t making any bets and thus active managers must therefore be trading against each other and cancelling each other out. That simple maths proves this point to be true.
There is no flaw in this logic, in the very broadest sense it must be accurate. However it does not preclude scenarios or areas of the market where persistent outperformance of a portion of active managers means they are able to beat the market.
The theory does not definitively prove that the active funds for sale to UK investors are destined to produce average returns and underperform trackers, however, as it relies on a set of assumptions that do not hold when applied to the funds investors are presented with.
They could, but as these funds make up a very small subset of market participants, it is entirely possible for them all to be profiting from the inefficiencies or incompetence of other market participants.
From this I can identify further areas of study that may help investors choose between active and passive funds.
When I come to producing my own research, I will try to identify if the managers of active funds available to retail investors are significantly superior to the average market participant, and if there is any region or market where this may be more likely.
Additionally I will be trying to identify "enabler funds", segments of the market or groups of market participants that are distinctly worse than the average participant, thus guaranteeing outperformance elsewhere.
This paper was a theoretical work, so finding problems in its application is not surprising. The real fun will begin when we start looking at some of the empirical analysis. This has been used as the basis for some of that empirical work, however, and so is worthy of study.
Of course this is just one interpretation of the paper; to make this more of an open source research project I’d be interested to hear if others have a different take, or ideas for studies to further examine the conclusions.
Research on passives vs actives: William Sharpe and zero sum theory
Verdict: Inconclusive
Rob Gleeson is head of FE Research. The views expressed here are his own. He will be reviewing and analysing economic research from a number of contributors in upcoming articles, as well as putting his own research in.
