Jennifer RoathBUSA 335December 3, 2008Assignment 4

A Resolution of the Active versus Passive Debate

I. IntroductionMembers of the financial world perpetually debate whether passive or active fund

management produces the best results for the investor. There are pros and cons to both arguments, but according to extensive empirical evidence, the passive fund management approach is better than active for the average low risk tolerance investor.

II. Support for Active ManagementThe nature of active management is such that it attempts to beat the market by

continually adjusting the holdings of a fund in order to achieve maximum returns. On the other hand, passive management essentially is a tool for ‘buying the market,’ so by its nature, they will never beat the market. During a bear market active fund management actually has some chance of finding securities that are able to maintain their strength even though the economy as a whole is in recession. The managers of active funds are able to take evasive action to minimize damages. Continually, if an individual holds an indexed fund during the burst of a market bubble, it is very unlikely that the losses incurred from this burst will be recovered in the long run. Herein lies the main advantage of active funds; the fund manager is able to make an effort to increase returns by buying and selling securities to work with the current market.

The idea behind the support of active management is that the manager should be able to detect pricing imperfections and make arbitrage swaps, observe strengths of specific sectors and industries, and adjust the maturity of the portfolio in order to account for interest rate changes. These observations lead to the common, logical conclusion that active management is naturally better than passive management.

Robert C. Jones (1998) points to the generally accepted failure of the relationship between CAPM beta and stock returns as studied by Black, Jensen, and Scholes (1972) and Fama and French (1992). As Jones (1998) argues, this implies that either the market is inefficient or that investors don’t rely on the CAPM model to make decisions, and further that there is no single index that is the best answer for every investor. Moreover, as evidenced by the proven return patterns of anomalies such as the low P/E effect, the size effect, book to market value, and more, there are ways to consistently achieve higher returns than the market.

Wermers (2000) and Pinnuck (2003) observed the trades performed and individual securities held by portfolio managers in the U.S. and Australia respectively. The evidence concluded that managers were able to make superior returns on purchases, but there were no statistically significant superior returns on sells. Pinnuck suggests that managers have no superior information concerning bad news, but they do for good news. Both he and Wermer concluded that stocks held at the end of a calendar period had abnormal returns. This would be caused by portfolio managers selling weak securities and holding their strong securities. It is significant to consider that these studies are subject to survivorship bias and time period limitations.

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Exhibit 4 shows the percentage of U.S. mutual funds that outperformed the S&P 500 for the years 1977 through 1997. In looking at this bar chart, there is a significant percentage of superior performers during this range of years.

The evidence that supports active management is unconvincing. It relies more on theories and dependence on market inefficiency than on solid, empirical evidence. In fact, there are many researchers that assert that the studies that claim to prove that active management produces higher returns use skewed measurements.

III. Refutation of the Support for Active ManagementHowever, there are various reasons that actively managed funds are not efficient

investments. Actively managed funds require the payment of higher fees by investors in order to pay for the expertise and time of the fund managers. Hirt et al. (2008) points out that whereas index funds charge around 0.20% in fees and expenses, actively managed funds charge from around 0.75% to 1.25%.

John Bogle (1999), founder of Vanguard has said, "[O]ur hypothetical fund investor has earned $1,170,000, donated $700,000 to the mutual fund industry, and kept the remainder of $470,000. The financial system has consumed 60% of the return, the fund investor has achieved but 40% of his earnings potential… Confronted by the issue in this way, would an intelligent investor consider this split to represent a fair shake? Merely to ask the question is to answer it: 'No.'"

In addition, they take on more risk than passive funds. As Satchell et al. (2003) points out, in order to cover the fees that are charged, active funds take on large positions that are inherently more risky and have the chance of large losses. Though risk offers a chance for gain, it also presents the chance of negative risk and losses. Gains are only achieved when the manager’s bets are correct. In an efficient market, these active fund managers should not have any superior knowledge or information to make more insightful decisions than the average investor. If the managers believed in their personal ability to consistently maintain a superior portfolio, it is unlikely they would be sharing the profits with a paying public.

Even when higher returns are achieved, they involve higher risks. Risk is measured by the distribution and variability of possible returns. As can be seen in Exhibit 1, market funds produce returns along a straight line, but the distribution of the professionally managed funds is widespread. This represents a high level of risk. Even though there are a number of funds that achieved higher returns than the market, and even a few with extreme returns, there are also a nearly equal number of funds that fell below the performance of the market. There is a nearly equal likelihood that an actively managed fund will achieve superior or inferior results as compared to the market.

In reference to Exhibit 4, which seems to show that active management produces higher returns than passive management, it is important to consider the missing information. There is no indication of the degree of over-performance, which may be negated when fees, expenses, and taxes are subtracted.

Exhibit 5 provides further evidence that mutual funds commonly do not outperform the market. This graph shows the percentage of general equity funds that are outperformed by the market index for each year between 1963 and 1998. These arguments, in conjunction with the following evidence, shows that passive management produces higher returns than active management and that managers are not able to produce consistent results.

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IV. Evidence in Support of Passive IndexingThere are many studies in the financial literature that have tried to reconcile this debate.

They tend to conclude that there is no statistically significant difference in returns that should be expected from active fund management as compared to passive management. One of these studies was conducted by John G. McDonald (1974). As evidenced in Exhibit 1 (attached), in a comparison of the market line with 123 mutual funds between 1960 and 1969, there is roughly the same number of funds that outperformed and underperformed the market. On a risk-adjusted basis, there was no evidence that fund managers could consistently beat the market.

Another such study was conducted by Michael C. Jensen (1968), in which Jensen reviewed the performance of 115 mutual fund managers. He found that on a risk-adjusted basis over the period from 1955 to 1964, the average mutual fund produced a return before management expenses of 0.1% lower than an investment of comparable risk in a market index. This concludes that there is no evidence that managers are able to consistently outperform the market.

Another significant study in this debate, conducted by Brown et al. (1997), looked at pension fund managers’ performance in the UK. By using risk-adjusted returns, ranking the managers by performance, then arranging them into quartiles, they were able to monitor the movement of fund managers’ performance from year to year. In this study, and a similar study conducted by Blake et al. (1999), it was found that there was very little persistence of performance between periods. Blake et al. found that funds had a 0.4% superior return over the bottom quartile in the period following the fund’s ranking in the top quartile. In the U.S. fund market, Lakonishok et al. (1992) did find some consistency on the other hand. Though year-to-year performance was not consistent, there was evidence of consistency over two- or three-year time horizons. Even for the consistently high-performing managers, though, expected returns net of fees still fell below the S&P 500 index.

Robert C. Jones (1998) further added to the support for passive funds in his compilation of data. He provides the illustrations of Exhibits 2 and 3 (attached) to show that active managers underperform passive benchmarks on average. Exhibit 2 shows the percentage of funds that have outperformed the S&P 500 index during the given time periods. These measures were taken after fees and expenses were deducted, but before taxes. If taxes were taken out, the case for indexing would be even stronger. Exhibit 3 juxtaposes returns of median large-cap funds (this sample included all funds in the Lipper “Growth” and “Growth and Income” categories) and the returns of the S&P 500 for each year from 1979 through 1996. As can be seen in the graph, the S&P 500 outperformed the median large-cap fund for twelve of the eighteen years.

V. Concluding EvidenceThrough observation and reasoning, it becomes obvious that passive fund management is

the superior choice for most investors in consideration of risk. First of all, because passive funds have lower turnover than actively managed funds, they are more tax-efficient. With an active fund, it is possible to have large tax liabilities in addition to absorbing losses on a losing fund. Continually, even when returns are higher from active funds, the inclusion of expenses and fees may bring the excess return – which is calculated by subtracting the risk-free rate, expenses and fees from the total return of a security – below the market line.

Related to the issue of trade frequency, it has been proven that the long-term investment strategy produces the highest returns. Strong (2000) mentions a study conducted by Morningstar, Inc. that compared 278 U.S. mutual funds during the period April 30, 1981 to April 30, 1990.

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The study ranked funds by their portfolio turnover rates, and those in the lower quartile – those with the lowest turnover – had an average annual return of 15.8% as compared to an overall market average of 15.1%. Though this is not large difference, it shows that high portfolio turnover, as is common in actively managed funds, may reduce performance and returns. By their natures, passive indexing holds securities long-term with minor adjustments while active fund investing makes frequent sales and purchases in search of quarterly and annual return measures.

VI. ConclusionDespite the fact that some research has shown that active management can produce

higher risk-adjusted return, the bulk of the evidence supports the application of passive fund management for most investors. Although passive funds will generally not beat the market, there is a smaller range of performance outcomes which translates to less risk. There are studies that show that active funds have no statistically significant superior or inferior returns as compared to passive indexing. Based on these conclusions, there is no logical reason to take on more risk for an investment that will not statistically produce better returns, and will instead require higher fees and tax liabilities.

Even in the case where higher returns are achieved from active management, the average investor would be better off investing in passively managed funds. Instead of increasing risk exposure, a smart investor will use leverage by borrowing at an interest rate near the risk-free rate to increase his or her investment in a market indexed fund with less risk. By maintaining the market risk level and using leverage, returns higher than the market rate are possible.

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Exhibits

Exhibit 1

Source: John G. McDonald, “Objectives and Performance of Mutual Funds, 1960-1969,” Journal of Financial and Quantitative Analysis, June 1974, p. 321. Copyright 1974.

Exhibit 2

Source: Robert C. Jones, “The Active versus Passive Debate: Perspectives of an Active Quant,” Active Equity Portfolio Management, ed. Frank J. Fabozzi, p.38. Copyright 1998.

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Exhibit 3

Source: Robert C. Jones, “The Active versus Passive Debate: Perspectives of an Active Quant,” Active Equity Portfolio Management, ed. Frank J. Fabozzi, p.38. Copyright 1998.

Exhibit 4

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Exhibit 5

General Equity Funds Outperformed by the S&P’s 500Index 1963-June 30, 1998

Source: Bogle, John (1999). Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (119). Wiley, Johns & Son, Incorporated.

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ReferencesBlack, F., Jensen, M.C. and Scholes, M.S. (1972). The capital asset pricing model: Some

empirical tests. In Jensen, M.C. (ed.) Studies in the Theory of Capital. New York:

Praeger.

Blake, D., Lehmann, B.N. and Timmermann, A. (1999). Asset allocation dynamics and pension

fund performance, Journal of Business, 72, 429-461.

Bogle, John. (1999). Common Sense on Mutual Funds: New Imperatives for the Intelligent

Investor. (119). Wiley, Johns & Son, Incorporated.

Brown, G., Draper, P. and McKenzie, E. (1997). Consistency of UK pension fund investment

performance, Journal of Business Finance and Accounting, 24, 155-78.

Fama, E.F. and French, K.R. (1992). The cross-section of expected stock returns, Journal of

Finance, 47, 427-65.

Hirt, Geoffrey A. and Block, Stanley B. (Eds.) (2008). Fundamentals of Investment Management

(9th ed.) p559. New York: McGraw-Hill/Irwin.

Jensen, Michael C. (1968). The Performance of Mutual Funds in the Period 1955-1964, Journal

of Finance, May 1968, 389-416.

Jones, Robert C. (1998). The Active versus Passive Debate: Perspectives of an Active Quant. In

Fabozzi, Frank J., Active Equity Portfolio Management (37-55) New Hope, PA: Frank J.

Fabozzi Associates

Lakonishok, J., Shleiger, A. and Vishny, R.W. (1992). The structure and performance of the

money management industry, Brookings Papers on Economic Activity: Microeconomics,

339-79.

McDonald, John G. (1974). Objectives and Performance of Mutual Funds. Journal of Financial

and Quantitative Analysis, June 1974, 321.

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Pinnuck, Matt. (2003). An examination of the Performance of the Trades and Stock Holdings of

Fund Managers: Further evidence. Journal of Financial and Quantitative Analysis, 38 (4)

Satchell, S. and Scowcroft, Alan. (2003). Advances in Portfolio Construction and

Implementation. Boston: Boston: Butterworth-Heinemann.

Strong, Robert A. (Ed.) (2000). Portfolio Construction, Management, and Protection, (2nd ed.)

p343. Cincinnati: South-Western College Publishing.

Wermers, R. (2000). Mutual Fund Performance: An Empirical Decomposition into Stock-

Picking Talent, Style, Transaction Costs and Expenses. Journal of Finance, 55 (2000),

1655-1695.

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