Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
  • T613.237.5544 x 313
  • 1.800.230.5544
  • F613.237.5949
  • 265 Carling Avenue,
    8th Floor,
  • Ottawa, Ontario K1S 2E1

Scale and Skill in Active Management

In a recent academic paper written by Lubos Pastor (Booth School of Business) Robert F. Stambaugh (The Wharton School) and  Lucian A. Taylor (The Wharton School), the size of actively managed mutual funds, the size of the actively managed mutual fund industry, and the skill of active mutual fund managers were studied to determine how they affect the performance of actively managed funds.

The study found that the size of an actively managed fund does not have a significant correlation with performance, but the size of the actively managed fund industry does have a significant, and negative correlation with fund performance. The data showed  that a 1% increase in the size of the actively managed fund industry comes with an almost 40bp decrease in the annual performance of the sample of funds examined. The data seems to show that as the size of the actively managed fund industry grows, markets become more efficient.

One of the most interesting parts of this study as it relates to efficient markets is that the returns attributable to fund manager skill have actually increased over the period 1979-2011. The authors consider that the increase in measured skill could be attributed to manager experience, education, or the better use of technology, but it hasn’t been evident in returns because of the negative correlation between industry size and actively managed fund performance.

This paper confirms that competition drives the efficiency of markets; as more entrants compete for alpha, it becomes more difficult to generate. Knowing that it gets harder and harder to beat the market as more people invest in beating the market, and keeping in mind that the cost of an actively managed dollar generally exceeds the cost of a passively managed dollar, the question of why people continue to invest in active mandates is difficult to answer.

By: Ben Felix | 0 comments

The Grosman-Stiglitz Paradox

At PWL, we often cite efficient markets as one of the building blocks of our investment philosophy. We believe that because all available information is included in the prices of securities, and new information is random, we are better off capturing the performance of the market rather than trying to identify which company, asset class, or region will be the next big winner. Our market-based strategy is backed by years of data, but if all available information is factored into the prices of securities, someone must be doing the research, right? This is a paradox, and it has a name. The Grossman-Stiglitz paradox states:

If markets are efficient and securities' prices reflect all available information and, obtaining information about securities requires resources (time, money)

Then, why do people commit resources to researching securities at all, and if people don't commit resources to researching securities, then how did the prices get right to begin with?


This appears to be difficult to wrap the mind around, but it is a very simple relationship. Mispricings of securities occur randomly as new information develops. If there are people that think they can consistently exploit mispricings, they will spend their resources to exploit them. It only takes a few exploited mispricings to make people believe that they can consistently find more mispricings. When there are enough people trying to exploit mispricings, the prices of securities will tend toward their true value as soon as new information appears. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. As much as this is a paradox, it plays out as an equilibrium in the market.

So what would happen if the majority of investors started to buy the market and stopped trying to beat the market? Mispricings would start to develop regularly, and the people that had continued to try and pick stocks would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. Behavioral finance plays a huge role in market efficiency; nobody wants to accept being average by taking what the market gives them when there are hot shot managers that promise to consistently beat their benchmark. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.

At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and remember: whenever one active manager beats the market, another must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average over the long term than to outperform the market one year and underperform the next.

People naturally want to beat the market, and they will continue to try no matter what the evidence shows. These people that are set on beating the market are the people that keep the markets efficient; we need the dollars paid to actively managed funds to pay for the constant research that drives the market’s near-perfect pricing mechanism. An efficient market is not a free lunch, I'm just glad our clients aren’t the ones paying for it.

By: Ben Felix | 1 comments