The Hurdles Are Getting Higher For Active Management

The goal of actively managed funds is to generate alpha – returns above the appropriate risk-adjusted benchmark. We might add here that the alpha should also be sufficient to compensate for the increased idiosyncratic risks active managers take by failing to fully diversify, and that the only way to generate alpha is to hold a different/less diversified portfolio than the benchmark.

As economist William Sharpe pointed out in his famous paper, “The Arithmetic of Active Management,” before costs active management is a zero sum game, and after costs it’s a negative sum game: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” In other words, for active managers to be successful they must have victims that they can exploit. Who exactly are these victims?

Read the rest of the article on Seeking Alpha.