The Economics of
Pension fund management needs improvement.
Robert G. Snigaroff
he pension fund and institutional investment
T purchasers of asset management services
frame the debate of active or passive man-
agement in philosophical terms, using such
phrases as “I believe (or don’t believe) in active man-
agement.” Then they hedge their bets by deciding what
percentage of their funds should be passively managed.
Academicians debate market efficiency using language
like “the semistrong-form of market efficiency hypoth-
esis,” and produce research attesting to the general folly
of active management. Investment management firms
simply want the job of managing someone’s money. Of
course they believe in active management, or at least those
who aren’t cynics do.
A more formal approach to the way pension fund
buyers of asset management services think about the active
management market and the way they apply their think-
ing could not only help clients improve their operations,
but could also impact the market for those services.
SUPPLY, DEMAND, AND THE
ALPHA PRODUCTION POSSIBILITIES CURVE
For purposes of illustration, the supply of active
management is drawn in Exhibit 1 as relatively flat, or
ROBERT G. SNIGAROFF is elastic. Factor inputs to active management suppliers, such
chief investment officer of the San as the salaries of investment professionals, systems, and
Diego County Employees Retire- infrastructure, are net, fairly constant regardless of quan-
ment Association in San Diego (CA tity supplied. Such inputs may even fall with increased
92101-2427). output, resulting in a downward-sloping supply curve.
WINTER 2000 THE JOURNAL OF PORTFOLIO MANAGEMENT 1
It is very difficult, however, for buyers to find and corresponding increase in the aggregate dollars of pro-
to distinguish suppliers with talent from those without duced value; i.e., the dollar amount of value that is added
it. Because of this, suppliers build distribution franchises to buyers of active management increases with the
resulting in significant hurdles for new entrants. Gener- amount of assets employed to produce it. At point A,
ally, the firms that provide active management have high the curve reaches its highest point; that is, the contin-
margins after they are successful in attaining scale. Buy- ued addition of active management supplied results in a
ers of active management are willing to pay a premium maximum dollars of produced value. After point A, there
to firms that are able to add value, as they may employ begins a reduction in produced value for buyers.
talented professionals or have a valuable intellectual or Transaction costs grow with supply. Although
operational franchise. Marginal costs for suppliers are rel- transaction costs are outside the alpha curve (by defini-
atively low after fixed costs are met. tion, alpha is produced value after transaction costs), the
Whatever the shape of the supply curve, buyers fact that they grow with trade size contributes to a value
of active management create a demand curve for active decline. And of course the market, if it’s trading with
management that impacts the production of alpha. The itself, can’t beat itself.
supply and demand curves represented in Exhibit 1 por- Even if we allow that there is alpha available to
tray a monopolistic competition. Buyers can influence the entire universe of active management because of its
both the demand curve and the alpha production possibil- role as providers of liquidity to the market or because
ities curve in order to improve their prospects in actually of non-wealth-maximizing market participants, there is
producing alpha. a maximum dollars of produced value. There is also a
The production of excess return, or alpha, can be unique alpha curve and maximum dollars of produced
modeled as an alpha production possibilities curve (here- value for each subset of active management buyers.
after alpha curve), as shown in the bottom half of Exhibit Ideally, the pension fund buyer subset, in the
1. As the supply of active management rises, there is a aggregate, would like to be positioned at point A on
the alpha curve. It may be, however, that these buyers
are instead positioned at point O, oversupply. If pen-
EXHIBIT 1 sion fund buyers are positioned on the alpha curve at
SUPPLY OF ACTIVE MANAGEMENT point O, they are failing in their business efforts to pro-
duce alpha — they are, in fact, in the region of man-
aged value reduction.
At point O, the demand curve intersects supply
Price of Active Management
S at Q2 in Exhibit 1. If buyers of active management are
not as informed as sellers, then the demand curve would:
Q1 1) likely have a steeper slope; i.e., demand is inelastic,
D2 and 2) be positioned farther out on the supply curve
(buyers buy too much active management).1 The demand
curve would look like D2 in Exhibit 1.
On the first point, the fact that the percentage of
D1 pension fund assets managed actively and the fees sell-
ers charge buyers have both remained constant suggests
demand inelasticity.2 On the second point, uninformed
Dollars of Produced Value
buyers would tend to overestimate the actual size of the
alpha curve and so overbuy.
A Much research suggests an inability to add value
by the average supplier of active management, hinting at
oversupply, hence the intersection at Q2. Consistent with
O this research is new work by Ambachtsheer, Capelle, and
Region of Managed Value
Reduction to Pension Funds Scheibelhut  arguing that, on average, the pen-
sion fund buyers of active management are in fact reduc-
Quantity of Active Management Supplied ing value for their pension fund stakeholders.
2 THE ECONOMICS OF ACTIVE MANAGEMENT WINTER 2000
THE PRINCIPAL-AGENT ISSUE EXHIBIT 2
SHIFT IN CURVES FOR ACTIVE MANAGEMENT
Demand curve D2 is consistent with the presence
of a principal-agent problem for pension fund organi-
zations, where agents are not acting to meet the objec-
Price of Active Management
tives of principals (maximization of risk-adjusted S
returns).3 In the pension fund context, the principals Q3
include both the fund’s beneficiaries and the plan spon- Q1
sor. The beneficiaries are principals as the fund exists to
make current, and future, payments to them in retire-
ment. The plan sponsor is a principal because it reaps D3
the benefit, and assumes the risk, of any asset-liability D1
mismatch. (Here we are considering the economic prin-
cipal-agent definition, and not the legal.)
Lakonishok, Shleifer, and Vishny [1992, pp. 374-
Dollars of Produced Value
375] posit an agency problem in pension fund man-
agement, and suggest a possible source of the problem
as the desire of the treasurer’s office (i.e., pension fund
management) to look similar to other funds (reduction
of maverick risk) and to retain its own “empire.” They
even suggest that employees in the treasurer’s office may Region of Managed Value
be “frustrated stock pickers,” or perhaps “excessively Reduction to Pension Funds
risk-averse” and in need of a “good story to explain
Quantity of Active Management Supplied
poor performance to their superiors inside the spon-
Assignment of blame is, in fact, a cultural fea-
ture of pension funds. O’Barr and Conley  and to the right, allowing a corresponding shift in the
observed the behavior of pension fund managements optimal demand curve to quantity Q3. This is the prefer-
and find culture to be a more important decision driver able solution for suppliers of institutional active man-
than economics. agement. A move to Q3, however, means that there is a
To say that the pension fund community’s busi- corresponding erosion in someone else’s alpha curve. The
ness practices are a result of culture, though, is simply a game becomes, how we, the pension fund community,
dead end. Ascertaining how funds obtained this culture can carve into the alpha curve of, say, the buyers of mutual
and whether it can be changed is what is important for fund active management. Can we, the pension fund
pension funds and the active managers they hire. For this, community, use our economies of scale and infrastruc-
we can apply economic reasoning. ture to our advantage?
Principal-agency issues can be addressed by pen- In fact, we have already done so. For example,
sion fund organizations. Ambachtsheer, Capelle, and pension funds have succeeded in gaining tax exemp-
Scheibelhut , for example, argue that pension tion. Tax exemption is more than avoidance of confis-
funds with higher scores for optimal organizational lay- cation of a portion of the alpha curve to pay taxes. It
ering and clarity of delegation have better performance. allows the expansion of the alpha curve for market par-
In effect, what they are arguing is that agency issues can ticipants who can exploit their tax-exempt status through
be successfully addressed, and that the segment of the the consideration of additional alpha production strate-
pension fund community that has better business prac- gies (e.g., higher turnover strategies, or dividend pref-
tices has in fact addressed them and so has grown its erence strategies when income is subject to higher taxes
particular alpha curve. than capital gains).
The entire pension fund community can, in fact, Also, corporate pension funds and many public
grow its alpha curve with business practice improvements. funds enjoy a “prudent investor” standard with respect
This is shown in Exhibit 2, where A2 is shifted upward to the building of their investment portfolios. Del Guer-
WINTER 2000 THE JOURNAL OF PORTFOLIO MANAGEMENT 3
cio  has shown that market participants who are case in the public pension fund arena). In other words,
held to another standard cause market segmentation dis- the boards of institutional pension funds, which enjoy sig-
tortions by tilting portfolios toward investments that fidu- nificant economies of scale in retaining a professional man-
ciaries could defend as being “prudent.” (Del Guercio agement effort in order to produce alpha, not only do
looks at a “prudent man” standard where investment not pay enough to attract top talent in order to succeed,
vehicles are viewed as suitable only when viewed in iso- but also end up trying to produce the alpha themselves.
lation and not in a total portfolio context.) If a board committee decides how to produce
Also, pension funds build “transported alpha” alpha, it not only has to select superior asset manage-
portfolios using derivatives to give the alpha of one asset ment products, but it also needs to address complex issues
class (presumably less efficient and with a higher expected that don’t lend themselves to solution by what is usu-
information ratio) to another. This last case does not ally a part-time committee composed of non-investment
expand the alpha curve through preferential regulatory professionals.5 The first is that asset management firms
treatment, but rather through an application of the pen- usually have an economic incentive to grow beyond the
sion fund’s infrastructure. Pension fund managers can sep- most effective trade size for their clients.
arate the asset class return from the production of alpha, Second is the need for the optimization of alpha
and find the best sources for alpha production. This production. That is, it is the overall fit of a particular prod-
exploitation of market segmentation is much more dif- uct or strategy within the aggregate portfolio that mat-
ficult for individuals. ters, not the effectiveness of the strategy in isolation.
Creating strategies for alpha curve expansion is Third, research indicates that past performance
desirable for the pension fund community (buyers and matters little in forecasting future performance, and past
sellers), but such strategies do not solve the principal- performance is the very information that committees
agent problem. heavily rely on to add or retain service providers (along
with a short presentation by the service provider).6
THE PRODUCTION OF ALPHA Fourth, a committee must wade through an
astounding number of investment offerings and under-
If alpha production is similar to any other prod- stand the strategy of product proliferation that asset man-
uct the corporation (or public entity) might wish to pro- agement firms use to reduce their own business risk (not
duce, why do so many funds fail in its production? I believe necessarily with active management skill, but rather by
it is due to a principal-agent problem that pertains in many offering a range of products; see Ennis ).
pension funds and that has not been successfully Finally, firms that should no longer be in busi-
addressed. I don’t believe the problem is empire-building ness stay in business through their marketing by associ-
by fund managers; in fact, just the opposite. ation. (They exploit active management buyers’ lack of
Ambachtsheer, Capelle, and Scheibelhut  knowledge, weak management structure, and personal
are on to something when they write about the impor- and political connections.)
tance of pension fund governance and layering and del- Persson and Tabellini  have something to
egation. For example, there is a surprising lack of tell us about authority delegation. In the political world,
resources devoted to the pension fund’s internal man- they find “strong and robust support for the prediction
agement. The top pension fund governing body (or the that the size of government is smaller under presiden-
board), which spends as much or more than 50 basis tial regimes.” This research provides an interesting corol-
points of aggregate fund assets in external asset man- lary for the pension fund community.
agement fees, rarely spends more than 2 basis points on The authors find that a parliamentary government,
its own internal management. Fund managements, as a with its diffuse form of decision-making and account-
result, are staffed by executives who are poorly com- ability, increases politicians’ “positive rents for themselves”
pensated, aspire to careers on the sell side of asset man- (government is bigger and more expensive). This, they
agement, have short average tenure, are compensated contrast with governments with a “presidential” regime,
without regard to whether alpha is actually produced, i.e., a regime with more authority and visible account-
and are delegated very little authority.4 ability that is associated with less government and expense.
Boards often retain the authority to hire and fire The delegation of authority is also consistent with
active management suppliers themselves (in almost every the general change in the practices of U.S. business in
4 THE ECONOMICS OF ACTIVE MANAGEMENT WINTER 2000
recent years: the pushing down of authority to frontline agement buyers to be dazzled by the “mystique” of the
employees. Many pension funds (especially public market and the “money masters” is reinforced by sell-
funds) are practicing a centralized business model that ers trying to make a sale.
fewer and fewer of the companies they invest in con- This view only moves the question back one step
tinue to practice. without explaining how the pension fund active man-
Finally, the hypothesis that there is a pension fund agement industry arrived at its current condition. For
principal-agent problem as opposed to sellers with this, we need a brief dose of history.
monopoly pricing power is evidenced by the structure Through the 1970s the asset management indus-
of the asset management industry. Active management try looked different; bank trust departments dominated
sellers do not have a monopoly; there is too much indus- the management of pension fund assets. Before the mid-
try diffusion and too much fluctuation in market share. ’70s, all assets were actively managed. Pension fund assets
There are 392 active managers each managing grew dramatically through the 1980s and 1990s. Dur-
more than $1 billion in tax-exempt assets. Only six have ing the 1980s banks failed to reconcile the need for high-
2% or more of total market share, with the one man- quality professionals and their compensation schemes (a
ager maximum just over 4%. The Herfindahl index of problem related to the current pension fund dilemma of
industry concentration for all active managers is 120 quality management and inadequate compensation). They
for 1998, nowhere near the 1,000 index level the Jus- then lost their most important asset, skillful profession-
tice Department uses to define overconcentration. Con- als. The stand-alone asset management firms were formed
trary to much current commentary, industry in great numbers after these professionals recognized that
concentration has actually decreased; the Herfindahl they could capture the high margins associated with asset
index was at 132 in 1989.7 management themselves; talent is, after all, beneficial to
Even so, suppliers demonstrate pricing power. asset management buyers.
They have adopted what Ennis  describes as an Two general trends are occurring in asset man-
“adaptive” strategy of product proliferation resulting in agement today. The first is that some asset management
less well-informed buyers paying the same levels of active firms are “cashing out”: selling their businesses back to
management fees to a revolving set of suppliers. Sellers banks or other large institutions that want an equity stake
are adapting to the market in active management. Buy- in the business and that have enough capital to continue
ers are not. the expensive marketing of products. The second is rapid
product proliferation by which suppliers hope to have
a reasonable chance at offering benchmark-beating prod-
Given that a principal-agent problem exists, how ucts. As the level of complexity in the institutional funds
did the pension fund community get to where it is? One management market has grown, so too has the com-
reason is that the asset management firms, the consul- plexity of investment vehicles and strategies that pen-
tants, and other service providers are provided incentives sion funds use to try to succeed in alpha production.
to help boards focus on what’s not important. Service Organizational design within pension funds, however,
providers simply want to sell a service, and to make the remains as before.
sale they need to show their wares. They therefore sup- During the 1970s, an external entity (the bank
ply inordinate amounts of information testifying to their trust department) chosen by the board had oversight over
skill. They also spend significant resources in marketing the pension fund’s entire pool of assets. Now, in the bank’s
by association to the buyers of the services. Simply by stead, the board of the pension fund very often assumes
providing the enormous amount of information, and by oversight of the aggregate fund, and as it selected the bank
marketing, sellers move the focus from the pension plan trust departments, it still often chooses to select the asset
balance sheet and total fund managed value-added to management service providers. Following enactment of
investments and investment providers. the Employee Retirement Income Security Act and grad-
Buyers of active management, if they are the ual acceptance of portfolio theory, boards now have a
board, spend a great deal of time on the evaluation of far more complex task: building a portfolio with port-
active management service providers, instead of evalu- folio theory and a slew of specialized active managers.
ating the overall (and far more important) pension fund Frequently a board brings in a consultant to offer sup-
balance sheet issues. The tendency of the active man- port. The board often accepts the advice of the increas-
WINTER 2000 THE JOURNAL OF PORTFOLIO MANAGEMENT 5
ingly product-focused active management sellers, some- vey and use of the risk-adjusted net value-added, or
times preferring it to their own management’s.8 RANVA, performance metrics, which is the pension
Both at corporate and public pension funds, fund equivalent of the corporate economic value-added
boards tend to neglect planning for and evaluation of measurement.11 Some use the information ratio perfor-
management and infrastructure in order to produce alpha. mance measurement for evaluation of actual returns as
For example, the career track for a corporate pension fund compared to their policy returns.
investment professional is often a return to the corpo- The active management industry is capable of
rate treasury department.9 At public funds, managers are material change. Think about the change in the bro-
not given much authority, and they administer board kerage industry after the deregulation of commissions
directives as opposed to initiating their own. Often man- in 1975. Since 1975, average institutional commissions
agers are merely an additional screen for active man- for listed shares have dropped by as much as 80%, as
agement suppliers to overcome in selling their product asset management firms in both the pension and mutual
to the board. fund active management segments have demanded
Boards aren’t conscious “rent-seekers,” as there is unbundled (from research) commissions at lower cost.
relatively little rent, or self-benefit, in the continuation What helped foster this change was an economic align-
of their current business practices. They simply aren’t ment that properly motivated agents to act in the best
offered a better way of practicing business by the indus- interests of their principals; reduced commissions result
try that offers them products. Pension fund industry struc- in an improved active management product to gain or
ture is thus “path-dependent,” a result of its particular retain market share.
history that locks the industry into inefficiency. Pension funds would benefit similarly from an
improved principal-agent relationship in order to
Changing the Path
advance alpha production activities. Specifically, boards
Both corporate fund and public fund governing need to delegate responsibility to management, build suit-
bodies need to make improvements if they want to: 1) able infrastructure, align compensation of management
create value for their stakeholders, 2) keep plan spon- to recognize success in attaining their goals, and make
sors from forcing change, and 3) avoid possible legisla- management accountable for results. Finally, boards need
tive action concerning their business practices. Sooner to design their organizational structures so that man-
or later, plan sponsors and beneficiaries will begin to agement becomes the primary voice in the formulation
realize the success, or lack of success, of their pension of business strategy. For suggestions on how boards can
fund efforts to produce alpha. Likely, the realization will improve their overall oversight of pension funds, I rec-
come from the plan sponsor, as the beneficiaries are, in ommend Ambachtsheer and Ezra .
the parlance of public choice economics, “rationally Given a desire for individual pension plans to
ignorant.”10 attempt to produce alpha, there is a tendency for the pen-
In 1985, the Financial Accounting Standards sion fund community in the aggregate to slide down the
Board issued FAS 87, which requires that unfunded alpha curve from point A toward point O in Exhibit 1.
pension liabilities be moved to the balance sheet. Ide- Widespread adoption of performance-based fees paid to
ally, this increases the visibility of the pension fund asset management firms could alleviate this problem. Pen-
to the corporate plan sponsor, but on the down side, sion funds would need to manage the moral hazard of
FAS 87’s reliance on defensible asset return assump- giving asset management firms and the managers of the
tions allows corporate funds to use historical returns, pension funds an asymmetrical bonus payment, as pre-
which have been high recently. Generally, expected sumably neither would accept a penalty if they were to
future returns are not discounted to compensate. Cor- underperform. For this, pension funds need to adopt
porate funds can, in fact, thus “double-count” asset well-designed risk audit programs.
Many pension fund active management buyers SUMMARY
show a desire to evaluate their alpha production busi-
nesses. A significant number accept Ambachtsheer’s con- Active asset management is a zero-sum game.
tributions to pension fund governance, including Buyers who want to produce alpha in a zero-sum game
participation in the cost effectiveness management sur- have to be better than their competition. For pension
6 THE ECONOMICS OF ACTIVE MANAGEMENT WINTER 2000
funds, competition includes all other participants in active The “1993 Plan Sponsor Compensation Survey,” p.
management, including mutual funds, individual 11, reports for public funds an 8.6% participation rate in
investors, endowments, bank trust departments, institu- bonuses with a 7% mean bonus yielding a 60 basis point aver-
tional funds trading for their own accounts, hedge funds, age bonus. For corporate funds 73% of fund executives par-
and even each other. Pension funds do not now plan their ticipate in bonuses, but for only 27% is the bonus linked to
alpha production efforts using strategies to exploit their 5In corporate pension plans, boards are often made
competitive advantages. In fact, the pension fund com- up of senior corporate treasury personnel whose expertise
munity has a principal-agent problem that makes it dif- is corporate finance. In public plans, boards often include
ficult to even see whether the fund is successful in political appointees and representatives of current and future
producing alpha, and the design and execution of alpha beneficiaries.
production efforts suffers. 6See, for example, Kahn and Rudd .
The structure of the industry and the nature of 7Index calculated using data as reported in Pensions &
the product contribute to the tendency for pension fund Investments (May 17, 1999). Data are for tax-exempt asset man-
boards to be dazzled by investment advisors rather than agement firms’ market share for all active management firms.
conscious of management accountability and business The Herfindahl index is: H = S2 + S2 + S2 + … + S2 , where
1 2 3 n
issues. Research suggests the magnitude of the problem Sn equals the percentage share of the n-th firm in the mar-
and confirms a need for improvement. ket. See Gwartney, Stroup, and Studenmund [1995, p. 615].
In the market share for just top ten and top one hundred firms
Pension funds do not have to accept the
we see slight decreasing percentages of the total active man-
inevitability of the culture. They can successfully agement market.
address principal-agent issues. Some of them have, and 8Consultants generally are capable firms that can offer
the active management industry will adjust. sound advice, but they come with their own principal-agency
burdens: the selling of research and advice both to pension
ENDNOTES plans and money managers, directed brokerage, and so on.
The best business design calls for an accountable management
1See, for example, Ambachtsheer . as opposed to a joint management-consultant effort report-
2Cost effectiveness measurement data show the U.S. ing to the board. Pension fund boards could consider out-
pension fund average percentage of assets externally actively sourcing all their alpha production efforts to an outside service
managed is at 63.1% in 1997 versus 65.1% for 1994 and that provider. This would be desirable for the funds that have dif-
direct investment management costs are at 29.1 and 29.6 ficulty meeting market compensation rates for management
basis points for 1997 and 1994, respectively. Suppliers are or for small funds that want to produce alpha but have dis-
also able, with their segmented fee structures, to practice economies of scale.
9The “1993 Survey of Plan Sponsor Backgrounds”
multistage price discrimination — to use the normative term
favored by economists. Different prices for buyers with dif- reports 48.8% of corporate plan sponsor respondents “fore-
ferent demand can benefit buyers with more elastic see remaining at their current job between one and five more
demand and so reduce their prices. The offering of discounts years” (p. 29).
10Beneficiaries are most interested in the level of their
to the largest buyers increases trade size, however, and can
erode the ability to produce alpha for all clients (but not benefits, and the cost of monitoring the efforts of the pen-
supplier revenues). For discussion of incentives for firms to sion fund is not worth the effort. Even if the pension fund
grow beyond the optimum size for their clients, see Perold fails in its alpha production efforts, the reduction in its funded
and Salomon . ratio happens slowly over time, and is not material for a sin-
3We could look at other objectives, but our focus is gle beneficiary. Some pension funds have constituent retiree
on pension fund alpha production. groups that have organized themselves and monitor pension
455% of corporate and 47% of public fund executives’ fund activities. This type of activity will likely increase with
next career choice is work in consulting or at an investment improved communication via the Internet. Still, it’s the plan
management firm (according to “1993 Survey of Plan Spon- sponsor that is on the hook for any asset shortfall.
11Ambachtsheer and Ezra  define two pension
sor Backgrounds, Responsibilities and Career Plans,” p. 16).
These numbers are likely understated as they include some fund RANVAs: a policy and an implementation RANVA.
non-investment survey respondents who presumably have The implementation RANVA measurement would be appli-
career aspirations other than consulting or with investment cable to a fund’s ability to create value above its policy bench-
management suppliers. mark, and would be the appropriate measure for evaluation
of alpha production.
WINTER 2000 THE JOURNAL OF PORTFOLIO MANAGEMENT 7
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Structure and Performance of the Money Management Indus-
Ambachtsheer, Keith P., Ronald Capelle, and Tom Scheibel- try.” Brookings Papers in Microeconomics, 1992, pp. 339-391.
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ates Investments Institute, 1993.
Ambachtsheer, Keith P., and D. Don Ezra. Pension Fund Excel-
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Analysts Journal, July-August 1997, pp. 6-13. nal, May-June 1991, pp. 31-39.
Gwartney, James D., Richard L. Stroup, and A.H. Studen- Persson, Torsten, and Guido Tabellini. “The Size and Scope
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8 THE ECONOMICS OF ACTIVE MANAGEMENT WINTER 2000