For over thirty years, the discussion surrounding active management has been significantly influenced by William Sharpe’s groundbreaking work, ‘Arithmetic of Active Management,’ published in the Financial Analysts Journal in 1991. Sharpe, a Nobel laureate and protégé of Harry Markowitz, introduced a concept that has become a cornerstone for advocates of passive investing. His argument was straightforward: after accounting for fees, actively managed portfolios typically underperform their passive counterparts.
Sharpe’s thesis posited that while both active and passive strategies earn similar market returns before costs, the reality is that the fees associated with active management create a zero-sum game, which can even turn negative.
This assertion has resonated throughout the investment community, particularly during the surge in popularity of index funds. Investors often question the value of paying for skill when a market’s average return is readily available.
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Rethinking Sharpe’s framework
Despite the influence of Sharpe’s conclusions, it’s essential to recognize that his perspective was limited to a static view of the market. Later scholars, particularly Lasse Heje Pedersen, have challenged this notion by illustrating how active management not only redistributes returns but actively contributes to market dynamics and efficiency.
To illustrate, consider a scenario with one hundred investors, split evenly between passive and active strategies. The passive investors hold their positions, while the active ones engage in trading, incurring management fees of 2% annually. Over time, the active investors’ returns diminish due to these fees, a concept echoed by renowned investors such as Warren Buffett, who likened it to the story of the Gotrocks family, where trading activities ultimately erode overall returns.
The limitations of a closed system
However, Sharpe’s model implies a closed system where every gain by one investor results in a loss for another. This perspective neglects the dynamic nature of markets. Sanford J. Grossman and Joseph Stiglitz previously indicated in their 1980 paper that markets can reward those who effectively incorporate information into pricing. They introduced the idea of an equilibrium that recognizes the ever-changing landscape of investments.
Sharpe’s assumptions imply that markets are static, where no new companies emerge or disappear and only existing shares fluctuate. This oversimplification fails to account for the reality that markets are organic entities shaped by human behavior and evolving economic conditions.
Active management as a catalyst for change
In contrast, Pedersen’s insights reveal that active management plays a crucial role in shaping market structure. He highlights that even if all investors were to stop trading, markets would continue to evolve due to factors such as corporate actions and economic shifts. In his 2018 article, ‘Sharpening the Arithmetic of Active Management,’ Pedersen presents evidence showing that U.S. equities experience an average annual turnover rate of approximately 7.6%, while bonds see nearly 20% turnover.
Moreover, even passive investors must engage in some level of trading to maintain their portfolio allocations as market conditions shift. For instance, if an investor places funds into a broad index but neglects to react to market changes, their stake in the market will gradually diminish over time, as shown in Pedersen’s data analyses.
Creating value through informed decisions
Active managers, when they identify misallocations in capital—whether it’s companies squandering resources or those with high-return opportunities—are not merely trading assets; they are facilitating a flow of capital towards its most productive uses. By engaging in corporate governance, voting, and investment decisions, active managers influence which companies thrive, which innovations come to fruition, and how industries adapt to market demands.
The fees associated with active management should not merely be viewed as transaction costs but as an investment in a system that seeks to optimize market efficiency. Pedersen has demonstrated that there is an optimal level of resources dedicated to analysis in the market. If this threshold is exceeded, the potential for extraordinary profits diminishes, leading to a natural equilibrium.
The symbiotic relationship between active and passive management
Sharpe’s thesis posited that while both active and passive strategies earn similar market returns before costs, the reality is that the fees associated with active management create a zero-sum game, which can even turn negative. This assertion has resonated throughout the investment community, particularly during the surge in popularity of index funds. Investors often question the value of paying for skill when a market’s average return is readily available.0
Sharpe’s thesis posited that while both active and passive strategies earn similar market returns before costs, the reality is that the fees associated with active management create a zero-sum game, which can even turn negative. This assertion has resonated throughout the investment community, particularly during the surge in popularity of index funds. Investors often question the value of paying for skill when a market’s average return is readily available.1
Sharpe’s thesis posited that while both active and passive strategies earn similar market returns before costs, the reality is that the fees associated with active management create a zero-sum game, which can even turn negative. This assertion has resonated throughout the investment community, particularly during the surge in popularity of index funds. Investors often question the value of paying for skill when a market’s average return is readily available.2
