Do active fund managers outperform passive fund managers?

The answer depends on how you define performance, a recent study from the U.S. Federal Reserve concludes. If you define performance based on absolute returns, then yes, active funds outperform passive funds. If you define performance based on measures of risk adjusted returns, then no, active funds do not outperform passive funds.

Active managers vs passive managers: The battle of profit and returns

In their recently released study, Returns to Active Management: The Case of Hedge Funds, authors Maziar Kazemi and Ergys Islamaj document what they claim is a non-linear relationship between activeness and performance.  They conclude that active fund managers deliver higher absolute returns. While active managers delivered higher profits were higher, it came at a cost. Risk.

Active managers

When the authors measured risk adjusted returns, they discovered an inverse relationship. Based on risk management, moderately active funds outperform less active funds.  Once the level of trading activity increases past moderate, the performance of active funds declines, the study observed.

The paper didn’t dive into detail regarding this non-linear relationship, which is a fascinating topic to explore further because it points to how some active hedge fund managers adjust their strategy based on a macro view.  It did provided an interesting clue regarding certain active managers timing the sector investments.

They may not have known it, but this is a little discussed category of investment manager.

Active managers vs passive managers: Selecting an investing strategy

When the paper pointed out that certain fund managers have “skills in timing various segments of the market may follow a more active strategy,” these are hedge funds that identify market environment and select an investing strategy.

This category of managers are those that identify market environment and adjust investment strategy accordingly. It was recently adopted by State Street in their “Risk Aware” product, as reported in ValueWalk, but the strategy has been quietly used by other fund managers.

This is a fascinating subset of active managers who typically have a different risk management profile that warrants consideration.  Many such managers, often mathematically focused, tend to have higher upside deviation than downside deviation. The problem with measuring risk and reward of this category is most researchers use Sharpe Ratio or Standard Deviation as a measure of risk / reward or risk alone as in the case of Standard Deviation.  There are many problems with these traditional measures, but among them the fact that no risk distinguishment is made between upside (positive) and negative (downside) deviation.

Active managers

The second interesting study variable is that the BarclayHedge “Graveyard” hedge fund database was cited as an apparent source for research when they looked at “live and dead” equity long-short hedge funds.”  BarclayHedge is a well respected database, and in fact contains files on “dead” hedge funds that many researchers considered unrivaled. What’s interesting is that the “Graveyard” database of algorithmically based hedge funds skews heavily towards positive risk-reward ratios more so than long-time managers that are “alive.”  I’ve studied that database and its characteristics of “failing” funds is fascinating, very different from that of “living” funds in ways that would surprise a logical thinker.

Active managers vs passive managers: Risk profiles

Regardless of the database, however, understanding the characteristics of three components would make a significant difference in this study. The hedge funds that adjust strategy based on market environment, which typically don’t at an active level, are important to consider as a breakout to the study results because they have a very different risk profile.  Further, when considering risk and reward, Sharpe ratio and standard deviation are measures that penalize upside (positive) deviation to a higher degree than should be the case, adjusting the results.  Third, recognition should be given to the risk-reward profile of the “dead,” or Graveyard hedge funds relative to the live variety.

But perhaps these additions are for the next study.  This study surprised to a degree by highlighting the returns of moderately active managers being superior to passive managers on a risk adjusted basis.  My hypothesis is that if one were to break out the funds that can successfully identify market environment to adjust investment strategy those funds would perform highest of all categories.

The full study can be found  here