Chapter 5 Active vs. Passive Portfolio Management
An active portfolio manager seeks to achieve positive alpha, i.e., excess returns relative to the market, by applying his knowledge, experience, and in-depth analysis of individual assets. Therefore, the manager assumes that the market is not efficient and tries to select mispriced assets to generate excess returns. The passive portfolio manager, on the other hand, assumes that the market is efficient, that is, that prices reflect all available information, and attempts to replicate the average market return by building a diversified portfolio. He knows that stock movements follow a “random walk” and are therefore unpredictable for any individual stock. The passive portfolio manager achieves his goal with a quantitative strategy and assumes that the results will be stable over time. ETFs that aim to track indices are classified as passively managed in this thesis.
The question is which of the two types of portfolio management is preferable.
5.1 Results of the Literature
Researchers Fama and French studied the returns of active and passive portfolio management by designing factor models that led to a wide range of models commonly used today to analyze the causes of returns. Their theory states that passive investors earn passive returns that have an alpha of zero before costs. This implies that active investors also collectively have an alpha of zero before costs. This means that if some active investors have a positive alpha, other active investors have achieved a negative alpha. Indeed, Fama and French analyzed this behavior in more detail in (Fama & French, 2010), finding that value-weighted professionally managed mutual funds that invest primarily in the U.S. equity market have a slightly positive alpha before costs at the expense of active investors outside of professionally managed mutual funds. In addition, Fama and French attempted to use regression models to distinguish between luck and skill in active portfolio management. Their results suggest that some active managers in the top percentiles have sufficient skill to cover costs over the long run. Nevertheless, actively managed funds in the top percentiles have an estimated alpha after costs that is close to zero, which is also true for large, efficiently managed passive funds.
Similar results were obtained in (Pace et al., 2016a), which analyzed European and U.S. active and passive funds. The results show that none of them is superior by cost. They suggest comparing active and passive managed funds on a case-by-case basis by considering all expenses. When the tax advantages of passively managed funds are taken into account, they can be slightly advantageous for investors with a long investment horizon.
A different viewpoint was taken in (Shukla, 2004), analyzing the value of active portfolio management. The results show that some actively managed funds generate large positive excess returns. These funds often had a small number of assets, which could be due to the fact that portfolio managers had more capacity to analyze each asset in detail. This suggests that experienced portfolio managers can indeed generate stable excess returns over time. But in contrast, these same funds charge increased fees that negate the benefits to clients.
The last source analyzed passive and active EU equity funds in (Derenzis, 2019). It was observed that the top 25% of actively managed funds outperform passively managed funds, but the group of actively managed funds changes over time. This leads to increased risks for investors as they need to buy and sell funds at the right time. They also analyzed the increasing popularity of passively managed funds, whose market capitalization increased by more than 61% between 2014 and 2018. On the other hand, the market capitalization of actively managed funds increased by only 16% overall, indicating a significant shift toward passively managed funds. After comparing the aggregated performance after costs between 2009 and 2018, it was found that the group of actively managed funds with smaller market capitalization lagged behind the larger ones and the larger ones lagged behind the passively managed funds.
5.2 Aggregation of the Literature
In summary, it can be said that both strategies have their justification. On the one hand, it was shown that there are actively managed funds that can constantly generate positive alpha and share this in part with the investor. But this refers only to a small part of the actively managed funds. Passively managed funds cannot be expected to generate excess returns, but on average they often meet their benchmark tracking target. Since actively managed funds often incur higher costs, they must constantly beat the market, which carries an implicit risk. In particular, it was shown that many of the active funds with positive performance only managed to do so within a certain period of time before underperforming again. From these results, one could conclude that passively managed funds carry less risk for investors in the long run. Especially if external factors such as tax relief also apply. As passive management has steadily gaine popularity in recent years, it is also more future-oriented to develop and improve these strategies.