Conventional wisdom says that active equity managers underperform against the market, especially after you take the cost of active stock selection into account, and that asset allocation with a semi-passive selection approach is the best bet. But according to research coming out of Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE)’s Global Quantitative Research team, the active managers outperform both before and after costs, and that managers should be fighting against the constraints that prevent them from picking stocks.

Fund managers can be highly successful, if they’re active enough

“We believe that fund managers are not nearly active enough,” the report explains. “The range of possible returns offered by a stock portfolio is typically wider than an ‘asset allocation’ portfolio. So while the possibility of losses is also greater – active stock selection can make a considerable difference on the upside.”

Comparing the performance of U.S. mutual funds according to their level of activity backs up this point of view. To determine who was an ‘active’ stock picker, holdings were compared against the market index, and mutual funds with the highest deviation were considered to be more active. ‘Closet indexers’ were funds that held portfolios that matched the movement of the market index as closely as possible.

us mutual fund closet indexers

Active stockpickers beat every other category before costs, but they also had significantly higher net returns despite their slightly higher cost of business. While some investors have started to realize that active management is preferable, and funds have responded by claiming to be more active, the reality is that funds are drifting towards passive, ‘closet index’ investment strategies.

mutual fund

While it’s true that asset allocation is important and that overall market trends for your mix of assets is the biggest driver of profit or loss, actively picking stocks gives fund managers the best chance to beat the market and generate alpha.

“We believe it is far easier to value an individual stock in the medium term than it is an entire equity market,” the report explains. “We have absolutely no idea what the ten year return on the Japanese equity market might be, but we could hazard a guess for Nestle.”

The Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) report was compiled by Andrew Lapthorne, Rui Antunes, John Carson, Georgios Oikonomou, Charles Malafosse, Michael Suen, Josh Cherian.