Putting Active Management to the Test

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Michael Jensen

Once again from the University of Chicago, Eugene Fama's graduate student, Michael Jensen, published "The Performance of Mutual Funds in the Period 1945-1965," in the Journal of Finance, 1965. This was the first study of actively managed mutual funds that documented their investment professionals' failure to outperform the appropriate market indexes.

Jensen has made significant contributions to the academic literature. Michael Jensen ranks first out of over 8,000 economics authors, at the Social Science Electronic Publishing online database, with over 74,000 downloads of his research papers. A list of other performance measurement articles can be found here.

Jensen also added a risk dimension when comparing mutual fund performance. He adjusted returns of funds using Sharpe's volatility measure, beta. This incorporated the idea that investors who take more risk should receive a higher return. Overperformance or underperformance of an index may be due to exposure to more or less risk than a comparable index. Jensen found that if investors had held a broadly based portfolio of common stocks at the same risk level as the mutual funds, they would have earned fifteen percent more. Only twenty-six out of one hundred fifteen funds outperformed the market over the period of the study.

Jensen's dramatic study opened the eyes of both the mutual fund industry and investors. He pointed out that fund managers have access to extensive research, and that they do their jobs every day with wide ranging contacts and associations in both the business and financial communities. This begs the question: if the experts cannot do better than an index, then who can?

Jensen's study did not consider the federal and state taxes on the realized gains generated by the high turnover of these mutual funds. That problem was later studied by Robert Arnott in his paper, "Can Your Alpha Cover Your Taxes?" Alpha refers to a manager's return in excess of a market. When adjusted for all relevant factors, an active manager trading within a well-defined index will usually underperform that index due to the hurdle of the high costs of active management. The only way to get a return that is different from an index (before costs) is to invest in a portfolio that is different from the index. Since the index provides the only reliable source of long-term risk and return data, why would an investor choose anything else?