In March, we wrote about a yet to be published paper by Kenneth French called “The Cost of Active Management”. In this paper, French concludes that the total cost of the “futile search for superior returns” is 67 bps or about 10% of annual returns (resulting from management fees and trading costs). At the time, all we had to go on was a New York Times article about the paper by well-known financial commentator Marc Hulbert. A recent interview with French by the online newsletter Advisor Perspectives brought this paper back to our attention. The full study is now available online and we felt was worthy of a second, more detailed, examination.
Immediate benefits of active management
Institutions have increased their allocation to passive investing significantly over the past 20 years, prompting Advisor Perspectives to wonder if institutions wising up to high active management fees. Interestingly, French points to increasing institutional hedge fund allocations as evidence that they are not, in fact, becoming more passive after all:
Advisor Perspectives: “Institutions hold a significantly higher percentage of their assets in passive funds, as compared to individuals. As of 2006, DB plans held 31.2%, non-profits held 28.7%, and public funds held 52.7% of their assets in passive funds. Are institutions are wiser as to the negative sum consequences of active investing?”
French: “My initial reaction to the public equity data was that institutions were getting the message. After looking further, however, I am not sure this is the correct inference. For example, much of the explosive growth in hedge funds is driven by institutions. Thus, instead of paying fees of 100 basis points per year for actively managed mutual funds, institutions are paying 425 basis points in hedge fund fees. It looks like many institutions have not really embraced the passive story.”
French is right, institutions have not “embraced the passive story”. They have embraced the separate management of active and passive portfolios – of alpha/beta bifurcation. Indeed, French himself acknowledges in the Advisor Perspectives interview that markets are only semi-efficient – opening the door for all kinds of active management opportunities.
Aggregate benefits of active management
French doesn’t mince words with his central argument in the paper:
“On average, active investors spend 0.67% of the total market cap each year on what, in aggregate, is a futile search for superior returns. If we assume that society will continue to spend the current real dollar cost of active investing forever and that the expected real return on the U.S. stock market is a constant 6.7%, the capitalized cost is 10% of the current value of the market.”
But his conclusion makes you wonder…If we all invested passively, markets wouldn’t function – if every dollar flowed through, say, BGI into the stock market on a cap-weighted basis – relative market caps of different companies would never change. The whole purpose of markets – to allocate capital to the most constructive business opportunities – would remain unfulfilled (unless a non-market-cap weighted index such as fundamental indexation was used). There would be a sort of self-fulfilling inertia to market values.
There seems to be little question that in aggregate active management has a net cost. But then again, so does sales and marketing. I am always amazed at the amount of societies resources are out toward sales and marketing activities (conventions, advertising, direct sales, commissions etc.) In fact, according to the US Bureau of Labor Statistics, well over 10% of the American workforce can be categorized as being in “Sales and Related Occupations”. Their salary alone is nearly 5% of US GDP.
Now imagine a world without such waste. No salespeople or marketing budgets. No one to undertake wasteful and time consumer competition. No costly “getting the message out” about a certain product. Imagine how much we’d all save by simply having a central authority plan the economy – say, in 5-year increments. We could call this central authority the Bureau of Global Investing or “BGI” for short.
Of course, that’s been tried by some countries under different names and as counterintuitive as it seems, it never really panned out as expected. Functions that initially seemed wasteful and inefficient actually had the indirect effect of channelling resources toward the better, more efficient products and services.
Look, we’re not saying Kenneth French is a commie or anything. He’s actually in the AllAboutAlpha.com Hall of Fame. But passive management only really works if active management also exists. In a sense, passive management is a free ride on the “wasted” resources of active management.
In fairness, French explicitly recognizes the value of “price discovery” resulting from active management, but he appears to side-step the issue a little in the Advisor Perspectives interview.
Advisor Perspectives: “…Without active management, there would be no marketplace for companies to raise capital. The whole economics of the stock market would stop working if there was no active management. Doesn’t the benefit of active management (to society) go beyond price discovery?”
French: “I don’t include the cost of marketing securities; I only include the cost of trading them. Since I do not include the cost of road shows to convince people to invest in initial public offerings, it does not make sense to include the benefit of this process in my analysis either.”
IPOs aside, active management benefits go “beyond price discovery” by keeping the marketplace alive. That benefit can’t possibly be excluded from such an analysis. So while we agree with French’s straightforward and elegant analysis, we might not be so quick to dismiss the aggregate benefits of active management.
Others, notably active managers, may want to change the name of the french-fries in their cafeteria back to “freedom fries” in protest.