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/* Style Definitions */ table.MsoNormalTable {mso-style-name:”Table Normal”; mso-tstyle-rowband-size:0; mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-parent:””; mso-padding-alt:0cm 5.4pt 0cm 5.4pt; mso-para-margin:0cm; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:”Times New Roman”; mso-ansi-language:#0400; mso-fareast-language:#0400; mso-bidi-language:#0400;}Dear Editor,
Jack Gray and myself were disappointed in the general tenor of the cover story last month on passive versus active management and annoyed by some of the views expressed. Therefore, we would like to take this opportunity to “correct” some of these views. We have restricted ourselves to those that we think are most important which we will address in the order that they appear in your article:
1. The proposition on page 17 that the markets this time “overshot the downside”. It is not clear who should be attributed with this observation but it is a huge call typical of those made by individuals charged with selling active equity management. It would indeed be “different this time” to what we experienced in the two periods for which we have data which are most equivalent to the current situation – the 1930s and the 1970s when we both experienced several nonsustained bounces undoubtedly driven by encouraging (but probably biased) views such as that expressed in the article.
2. The questioning of the proposition on page 17 that active managers tend to outperform (underperform) in falling (rising) markets. Bird and Gallagher (2002) establish this to be the case across (almost) all of the developed equity and bond markets, largely reflecting that managers hold cash and so run portfolios with a beta of less than one. There may be exceptions to this but it is a useful proposition to which to adhere.
3. The proposition first mentioned on page 17 but consistently made throughout the article that this is a “great time to be active”. The basis for this proposition being that conditions are likely to result in us experiencing greater dispersion of active returns in the immediate future. This ignores the point made a zillion times by Bogle that active investing is by construction a zero sum game so only the “winners” will produce a sizable alpha which will be offset by the large negative alphas experienced by the “losers”. In other words we are in a period when active investment is more risky from the viewpoint of the client.
4. It is suggested that we have some type of panacea in the form of fundamental indexing (“Beta prime”). Rob Arnott and others have shown that using other weighting systems to market capitalisation when forming “passive” portfolios produce superior returns. The reason being that markets are inefficient and hence so are cap-weighted indexes. The existence of these inefficiencies provides a necessary but not a sufficient condition for active management. Asness and others have questioned whether these inefficiencies are best exploited using a dumb and expensive technique such as fundamental indexing.
