Why it's Never a "Good Time for Active Management"

How often have you read in the Journal that "now is a great time for active managers" or something similar in Bloomberg that might read "despite the environment being ripe for active managers, active managers still underperformed their benchmark." Another good one I see from fund managers is that the rise of passive / index ETFs creates more opportunities for active management.

I'm here to tell you that all of the above statements are based on a false premise. Whether the offender is just trying to garner attention or raise assets, or whether they actually believe this premise, the logic is false.

Let me illustrate a simple concept which proves it's never a good time for active management.

Let's take a top down view of the market. For simplicity sake, let's say the market is composed of active and passive investors. The passive investors (indexers) simply ride on top of whatever the active managers do. Conversely, the active managers work to find every source of alpha possible and deploy their capital as opportunities present themselves in the market.

In a completely frictionless world, the sum of all the active managers would equal the index.

However, we don't live in a frictionless world. We live in a world of transaction costs and management / performance fees. Thus, we need to modify our equation as follows:

The Index equals the average of all active managers minus fees. Thus, by definition, active managers will collectively never beat the benchmark, simply because they are the benchmark - minus fees.

In fact, this has been backed up empirically. Studies have shown that collectively, active managers fail to beat the benchmark by what is estimated to be the average of the industries fees.

This is another reason why it's so difficult for individual managers to "beat the market" consistently over time.

Assuming you're a perfectly average manager, your returns will fluctuate year to year, sometimes beating the market and sometimes not, but the math is simply working against you.

The media should instead focus on divergence of returns. There are periods when the divergence of returns among active managers may be higher or lower - providing an opportunity for good managers to separate themselves from the bad. But after you average out all the dispersion, the sum total will still be lower than the market.