Tradeless Nirvana

Q&A with IFA: Is There Any Type of Market Where Active Management Shines?

Tradeless Nirvana

Question: Does Passive management make sense in all market conditions?

Note: The question above was originally addressed in DFA’s Fama/French Forum. Professors Fama and French began their response with William Sharpe’s conclusion that the average active dollar must always underperform the average passive dollar.

“Active management is always a zero sum game, before fees, expenses, and trading costs, regardless of market conditions. If there are active winners, they win at the expense of active losers. And active management is always a negative sum game after costs. This is an algebraic condition, not a hypothesis. We call it equilibrium accounting.”

It is important to note that this conclusion applies over every segment of the global financial markets and over every period of time. Realistically, this fact does not stop investors from pursuing active managers because they can always rationalize their higher costs by saying that they expect to achieve above average returns. Unfortunately, since they don’t live in Lake Wobegon, they can’t all be above average. Clearly, Fama and French were aware that this answer alone was inadequate, so they cited their own research showing the futility of manager picking:

“Moreover, our research on individual mutual funds says that it's impossible to identify true winners on a reliable basis, even if one ignores the costs that active funds impose on investors. Funds that seem to be winners, based on past returns, were probably lucky rather than smart. After costs, that is in terms of returns to investors, there is no game to play; there is no evidence of managers with enough information to cover costs, other than on a purely chance basis. And there is no evidence that this depends on market conditions. If you are interested, see our paper Mutual Fund Performance.”

In an interview with Robert Litterman at the 65th Annual CFA Institute Conference, Fama quantified the devastating conclusion of that paper:

“Active management in aggregate is a zero-sum game—before costs…After costs, only the top 3% of managers produce a return that indicates they have sufficient skill to just cover their costs, which means that going forward, and despite extraordinary past returns, even the top performers are expected to be only about as good as a low cost passive index fund. The other 97% can be expected to do worse.”

As more and more investors have come to the realization that active management is a loser’s game, we have seen many of them abandon active for passive to the degree where it may now be a tipping point. To summarize, we wholeheartedly agree with Fama and French’s conclusion: “In short, passive management and passive investing always make sense.”