Active management

Active ManagementPresented by:Tammavisa (Tip), Joanne, Arthur

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.

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

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

Active Management Continuum

Passive Hedge Fund

Traditional Active

Degree of Activeness

S&P500 High BetaSPHB

S&P500 ETFVOO

Russell US Core Equity FundREASX

Pure AlphaClosed Fund

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

The Arithmetic of Active Management

• Before cost

• Cost

• After Cost

Return on Average Passive

ManagementMarket Return

Return on Average Active Management

= =

Cost of Active Management

Cost of Passive Management>

Return on Average Active Management

Return on Average Passive

Management<

Total Investment CostAllocation 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

traded146bps 11bps

Total Investment Cost

Fees, expenses and trading cost relative to aggregate market cap, in basis points, 1980-2006

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?

Model to assess the plausibility of investment management fees

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

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 set5. Skilled managers can be identified

Theory and Use of Active Management

• Theory:

Average investor earns negative alpha after fees

• What’s happening:

wide use of active management

TheoryPeople’s Choice

Survey: what would you do?

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

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)

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 − 0.5𝑃𝐺2− 1 S − 0.25𝑃𝐺𝐹

Extended Model – Extended Factors

• Tracking errors on 𝐸 𝛼 : 𝜎𝛼

• 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∗

Model Inputs

• Subjective Inputs:

- Investment Horizon

- Probability of selecting good manager

- Minimum required 𝛼*

- Confidence level to redeem funds

Result – sensitive analysis (incompelete)

Result – Investor heterogeneity

Results – investment horizon

•

Conclusion

• Certain investors rationally choose active management

• behavioral bias - Some retail investors

• Reconcile the theory with reality

Some facts – Difference Across Country

NZ active management US active management

Some facts – Difference Across Time

NZ active management US active management