In its newest white paper, “A More Balanced Narrative: Setting the Record Straight on Active Management,” the Investment Adviser Association’s Active Managers Council (AMC) addresses three common criticisms of active management that permeate the headlines and mislead investors -Active managers don’t outperform indexes. Active managers can’t outperform their indexes. It’s not possible to identify above average active managers in advance.

The paper, the latest in a series of research from the AMC, examines the current narrative surrounding active and passive investing and provides evidence that active managers can and do outperform their indexes and investors can identify managers more likely to outperform in advance.

“The growth of passive investment strategies is well-deserved, but in recent years, the narrative between passive and active has become unbalanced. Our paper presents a more balanced discussion of the factors that drive relative performance between active and passive investing, examines the methodologies for comparing the two approaches, and argues that passive investing is raising the bar for active managers,” said author David Lafferty, AMC Chair and Natixis Investment Managers Senior Vice President and Chief Market Strategist. “The narrative that passive is winning almost everywhere isn’t supported by either standard total return comparisons or asset-weighted return estimates.”

A few of the key findings from the paper include: 

Many Active Managers Do Outperform

The popular narrative has been that active managers are underperforming across all styles and during all periods. However, a review of the data shows that the relative performance of active managers against their index competitors varies across both styles and time periods.

Zero-Sum Theory Does Not Prove the Average Manager Can’t Outperform

While Sharpe’s “Arithmetic of Active Management” may be compelling in terms of the overall availability of alpha to active managers, the math doesn’t perfectly align with how active management is measured in industry practice. Excess returns can be skewed across managers, and there is meaningful “slippage” across categories and investor types. The fact that alpha in total must equal zero does not mean that the median professional manager in a category will have 0.0% excess return before fees (and negative excess return after fees).

Performance Benchmarks Are Oversimplified

With respect to performance benchmarks, the paper takes a close look at the SPIVA and Morningstar active/passive scorecards and explains how they provide an oversimplified view of the merits of the two approaches.

These frequently-cited scorecards arrive at different conclusions about the success or failure of a category of active managers because they make different assumptions. For example, the Morningstar Barometer measures passive performance using the returns of a group of index funds and ETFs (which include the impact of fees), while the SPIVA uses the index return alone (without subtracting fees). Another important difference is that the Morningstar Barometer asset weights all share classes to arrive at a fund’s total return, while SPIVA bases its analysis on the largest share class.^[1]

In many cases, the performance differential is obvious. When 90% of active managers underperform in a particular category over a particular period, it’s pretty clear the index was tough to beat, regardless of your assumptions. However, data showing 55% of active managers outperforming in a category shouldn’t be deemed success, just as 45% outperformance shouldn’t be considered failure. Active/passive performance comparisons can offer insight, but they are hardly precise.

It’s Possible to Identify Outperforming Managers in Advance

While no one is suggesting that active manager selection is easy, there are factors that can substantially increase an investor’s ability to identify a manager who will outperform.

Active Managers Are Raising Their Game

The competitive pressures from passive indexing are forcing active managers to raise their game. They are lowering fees, investing in investment processes, increasing portfolio differentiation and focusing on risk management.

“A More Balanced Narrative: Setting the Record Straight on Active Management” ultimately counters the oversimplified conventional wisdom that all passive is good and active is bad. In so doing, it illustrates a much more nuanced understanding of the pros and cons of both active and passive investing styles, and how each can play an important role in investors’ portfolios.

In this series of videos, author Lafferty discusses the white paper “A More Balanced Narrative: Setting the Record Straight on Active Management.

[1]Morningstar and SPIVA also use different classification criteria, so the funds included in a category may differ between the two scorecards.