This might not tied to exam so closely but have been haunting me in my head for a while. Hope I get saved by this forum
Very often during the CFA study, we came across the statement that on an aggregate level active management does not beat its benchmark taking additional cost into account. Then why they still exist?
If the statement is true on an average basis, there’s gotta someone losing money with active management and hence stop doing that, which will bring in survival bias and hence invalidate the statements (those remained with active management should be profitable).
If you listen to any of the DFA-approved advisors, they’ll tell you that active management is a loser’s game. And yet a good amount of the CFA curriculum is built around it. I think at the institutional level that enough people successfully exploit risk adjusted alpha to make it worthwhile. I have no idea how it’s done in the real world, but that’s my impression. For the everyday investor (i.e. 99% of us), passive investing is more likely to produce a better long-term result.
Like you said, “on average”. This implies that in active management, there are also some winners. A casino odds are never in the gamblers favor, yet people keep coming back for me because of the prospect of winning. Investing in active management is no different. Also, this is for pure active management … IE 100% active management. Forms of active management that over or underweight indices (enhanced indexing) has outperformed both passive and active management.
In my opinion, it’s mostly about psychological detachment. If I buy index funds, I feel at the mercy of some abstract thing called “the market”. However, if I put money in an actively managed fund, I get a sense of security, since some manager is presumably handling all the investment decisions. Plus, fee-based funds have a ton of marketing. Sales people are basically hired to get customers to act against their own interests. Because of this, behavior of customers is not always rational.
MarkCFail is correct. A particular manager may not be able to consistently beat the benchmark . But then no institution relies only on a particular manager. consistently . If everyone on earth piled into ETF’s and index funds , those vehicles would become so efficient that the returns to any investor would be zero. And then no one would invest in them . Which would start the cycle all over again when people drift towards active managers
If everyone piled into passive instruments, they’d capture the capital market rate of return, provided that there were at least some active investors to drive prices to their fair value.
That’s actually incorrect. If everyone piles their money on the ETFs, it means there are companies that are very overvalued given that it’s only purchased as a result of the market getting bigger. An ETF fund does not make it more efficient, as ETF are based on indices which are market cap weighted. Thus there are many opportunities to be exploited. They actually say, the more ETFs and Passive managers out there, the more beneficial for active management cause less managers are exploiting the intrinsic value compared to the traded value.
With more people trending to passive management I’m excited to see if there merit to this theory in the coming years! Although I also prefer that active portfolios generally exhibit greater volatility giving those that dollar cost average a little more help in (unintentionally) timing their down market investments and bumping up their return compared to the actively managed portfolio’s return.
In the retail office I work (about 13 brokers) people give you funny looks if you even dare to mention market efficiency and that the worlds most uneducated investors (retail brokers) are less capable than almost anyone of consistently beating the market. Ha ha, it’s just sad. these poor idiots think that their little technical analysis newsletters are going to help them crush the S&P. Truth is analysis and investment bring about market efficiency, if everyone stopped analyzing investments in order to make active portfolio choices in favor of passive index investing, the market would eventually loose some efficiency and opportunities would arise. That is why I love finance. That fact blows my mind. I am trying to make a career happen in an industry that has been proven through many academic studies to be 100% completely worthless. If there is a market for investment analysts, then people are willing to pay for the chance to beat the market whether it is hypothetically feasible over the long term or not. If they’re paying, I’ll gladly analyze. Investment analysis is an essential piece of properly functioning markets.
Look, I’m a DFA advisor and I think the CFA curriculum does a pretty decent job addressing the active/passive arguments. Much of analysis in the passive world comes down to multifactor analysis and risk assessment. True, as soon as too many folks index their portfolios, anomalies will pop up, causing more investors to engage in active investment, bringing prices back to their fair value supporting the cause for indexing.
I’m not an expert but I think you guys should read some academic-quality papers on market efficiency theory. It’s a paper-theory with many assumptions. Active investing is a zero-sum game in the end. Hell yea it is. 50 mil is lost on the market, 50 mil is gained on the market. Who’s losing the 50 mil, look at all the individuals managing their own money trading on questtrade after watching BNN. Yes the markets are efficient in the sense better investors (whether by skill or luck) are capturing those losses. One assumption of efficient market: All relevant information is publicly available at low cost. First of all, a lot of this “info” is in education and knowledge. Not everybody has taken courses in finance. Second of all, those who have this info, not all investors are rational. Not to mention it’s impossible to have all the info all the time. Some side dish info: 80% of my equity valuation class or fixed income class don’t know jack shit about pretty much anything. I might be in that 80%, i might not be. I might be the loser, or the winner. In aggregate, sure it’s a zero-sum game. But in real life, there are massive differences. One analyst can work 8 hours a day, another analyst can work 14 hours a day. On average, there are two analysts works 11 hours a day. WTF??? looool I am a believer of efficient market theory, I am not a believer of efficient markets.
I agree with all your points, but how do you go about identifying and exploiting anomalies in the marketplace to generate long-term alpha? I can swear up and down that markets do a poor job of setting prices correctly, but I sure as hell have a hard time finding someone who can make that work for my clients.
Theory is one thing, practice is another and I very much recommend (for after the exam of course) ‘Minding the Markets’ by David Tuckett. He looks at investment manager behaviour from a behavioural stand point and interestingly looks at the context and incentives imposed on managers which very much affects decision making irrespective of the value of investment analysis and theory.
