Active Management

1. Active
Management
Presented by:
Tammavisa (Tip), Joanne, Arthur

3. Risk and Return Feedback
Choosing active management in the asset class strategy decision may affect the risk
and return in the optimal asset allocation stage.
Asset
Allocation
Decision
Active
Management
Decision
But portfolio risk may actually not change by that much so the feedback loop
may not be a big concern.

4. Security Selection
• Whether the security selection should be active or
passive
• Passive: security and weights are chosen by the
market
• Active: security and weights are chosen by the
active manager

5. Outline
• Active Management Continuum
• Market Efficiency
• Costs of Active Management (Sharpe, Ennis, French)
• Alternatives to Passive Management (Ezra and Warren)
• Heterogeneity of Investors (Foster and Warren)
• Active management across countries and over time
• Assigned Funds and Active Management

6. Active Management Continuum
Passive Hedge Fund
Traditional Active
Degree of Activeness
S&P500 High Beta
SPHB
S&P500 ETF
VOO
Russell US Core Equity Fund
REASX
Pure Alpha
Closed Fund

7. Market Efficiency
• Markets are becoming more efficient over time due to:
1. Information technology
2. Financial software technology
3. Communications technology
4. Factors reducing friction
5. Institutional ownership and arbitrage

8. The Arithmetic of Active Management
• Before cost
• Cost
• After Cost
Return on
Average Passive
Management
Market Return
Return on
Average Active
Management
= =
Cost of Active
Management
Cost of Passive
Management>
Return on
Average Active
Management
Return on
Average Passive
Management
<

9. Total Investment Cost
Allocation among groups of investors
1980 2007
Individuals 47.9% 21.5%
Open-end mutual fund 4.6% 32.4%
Average fees and expenses for mutual fund (bps)
1980 2006
Expense ratio 70 85
Annuitized load 149 15
Total cost 219 100
Investment management cost for institutions (bps)
Value-weight average cost 34 23
Hedge fund (fund of fund) fees
1996-2007
Hedge fund fees 4.26%
Fund of fund fees 2.26%
Total 6.52%
Trading Cost
1980 2006
Annua turnover 40% 173%
Standardized by the amount
traded
146bps 11bps

10. Total Investment Cost
Fees, expenses and trading cost relative to aggregate market cap, in basis points,
1980-2006

11. Can active management beat the market?
• Investors would be 67bps bettered off by switching to
passive portfolio
• Empirical analysis seems to prove that active management
can beat the market?
• Improper measurement
• The passive manager may not be truly passive
• Active manager may not fully represent the “non-passive”
component
• The summary statistics are not dollar weighted
• So why continue active management?

12. Model to assess the plausibility of investment
management fees

13. Alternatives to Passive Investing
• Active management isn’t all about beating the
market
1. No readily replicable index is
available
2. Cap-weighted may not meet investors’
objectives
3. Standard cap-weighted index is inefficiently
constructed

14. Alternatives to Passive Investing
• Cases where active management can beat the
market
4. Investment environment favors active
managers
- Competitive advantages, investor differences,
index fails to cover all opportunity set
5. Skilled managers can be identified

15. Theory and Use of Active Management
• Theory:
Average investor earns negative alpha after fees
• What’s happening:
wide use of active management
Theory
People’s
Choice
Survey: what would
you do?

16. Active Investors’ Decision-making Process
Expectation
Formation
Fund/stock
selection
Performance
evaluation
New info
Adjustment
Information
set
- This process can be subjective at
certain stages.
- Decision sensitive to info,
Objectives etc.
- Reason this paper cares:
Investor heterogeneity

17. Model- Investor Characteristics
• Information set
- CEOs and students
• Expectation
-retail and institutional investors (fees)
-investment horizon
• Behavioral Bias
-pessimist and optimist (risk averse/risk seeking)

18. Model- Simple Model Design
• Average positive alpha before fees
- M unconditional average , S for good-bad spread, V for random variation
• Ability to select good managers and bad ones
- 𝑃𝐺, when 𝑃𝐺 > 0.5, ability>0, subjective
• Fade effect
- F, if M+S+V
• Option to replace
- when M-S-V, 𝑃𝐺 applies to new decision
Find the breakeven fees:
𝐸′ 𝛼 = 0 (after fees)
E 𝛼𝑖
= 𝑀 + 2.5𝑃𝐺 − 0.5𝑃𝐺
2
− 1 S − 0.25𝑃𝐺 𝐹

20. Extended Model – Extended Factors
• Tracking errors on 𝐸 𝛼 : 𝜎 𝛼
• Revised utility function (TE risk tolerance: T)
• Allows for high investment horizon: H
• More managers: N
• Boundaries for fade and flow effect:
- TNA*, F=f(TNA*,𝛿) ,𝛿 is fade factor
- PCT*, TNA(t) = TNA(t-1) (1+alpha(t))
• Boundary for redemption
- Minimum required alpha: 𝛼∗

21. Model Inputs
• Subjective Inputs:
- Investment Horizon
- Probability of selecting good manager
- Minimum required 𝛼*
- Confidence level to redeem funds

22. Result – sensitive analysis (incompelete)

23. Result – Investor heterogeneity

24. Results – investment horizon
•

25. Conclusion
• Certain investors rationally choose active management
• behavioral bias - Some retail investors
• Reconcile the theory with reality

26. Some facts – Difference Across Country
NZ active management US active management

27. Some facts – Difference Across Time
NZ active management US active management