Why Active Managers Lose

Interesting article at Bloomberg View. The authors address the puzzling reason why so many active managers lose to the indexes, even before fees.

The reason, they contend, is that stock returns are very unevenly distributed. The big winners are really, really big. So big that they skew the whole sample. So while the total index reflects that, it’s very hard for an active manager to select one of those few big winners.

Here is a simple illustration of our main idea:

Consider an index of five securities. Four (though we don’t know which) will return 10 percent and one will return 50 percent.

Suppose active managers choose portfolios of one or two securities and each investment is weighted equally. There are 15 possible one or two security “portfolios.” Of these, 10 will earn returns of 10 percent, because they will include only the 10 percent securities. Just five of the 15 portfolios will include the 50 percent winner, earning 30 percent if part of a two-security portfolio and 50 percent if it is the sole asset in a one-security portfolio. The mean average return for all possible actively managed portfolios will be 18 percent; the median actively managed portfolio will earn 10 percent. The equally weighted index of all five securities will earn 18 percent.

In other words, the average active-management return will be the same as the index, but two-thirds of the actively managed portfolios will underperform the index because they will omit the 50 percent winner.

It should be noted that there are some stock-pickers who have done quite well.

Posted by on November 11th, 2015 at 3:41 pm


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