Why higher dispersion of returns or FED policy will NOT help active management outperform.

Research reports by active management firms often make the following claims:

“The reason passive has been outperforming is that loose monetary policy has pushed all asset and security prices up, once the trend reverses active managers’ will outperform.”

“Active managers will outperform once the dispersion of securities returns increases, as not all asset prices will be rising.”

“Active and passive management outperform/underperform in cycles.”

When large investment companies research departments produce reports making such claims, I wonder if they don’t understand what are passive or active management. Worst, are they intentionally confusing the public? I believe it’s the former, but let’s elaborate why those claims are false.

Fed Policy and Active vs. Passive Performance

The Fed policy plays no role in whether active or passive management will outperform. It’s the case because as we established here “Passive vs. active“, all passive index funds do is copy the active managers. As a quick refresher, the active management community purchases and sells securities on perceived mispricings. By doing this, they establish the values of all the public companies. Passive funds purchase those same securities in the exact same relative weights the active managers have assigned them. Of course, unless not truly passive. For instance, any portfolio that is not value-weighted is active (equal-weighted index is an active portfolio, its bullish small caps). For example, if all active managers combined have assigned 1/10 of their assets to company X, the passive fund will assign 1/10 of its portfolio to company X. If company X produces 10% return throughout the year, both passive and active managers will get the same proportionate return. That is why before fees active and passive managers will have the same return. If the Fed is using loose monetary policy to push values up (increasing the money supply), both active managers and passive managers will generate the exact same performance, before fees, since both have the same allocation. The same applies if the Fed is neutral or has tight monetary policy.  

Dispersion of returns and Active vs. Passive Performance

If the dispersion of returns among securities is high (not up trending markets, for example), the dispersion among active managers performance will be high. That doesn’t mean active managers will outperform. What it means is that the good(lucky) active managers will be able to generate higher relative returns compared to the bad(unlucky) active managers. Again, passive managers copy the active managers as a whole, so they will produce the same return as all active managers put together, meaning the combined return of both good, lucky, bad, and unlucky active managers.

So, do active and passive managers outperform and underperform in cycles? No, because passive investing and active investing are just two sides of the same coin. They will both have the same performance before fees. Any report that claims otherwise is not measuring the performance correctly. For example, they are excluding active managers such as individuals, hedge funds, foreign investors, etc… Many reports also claim active manager outperform in bear markets, that’s not the case also, see Do active managers outperform in bear markets?

If passive investing just copies active investors, is it just like a parasite that feeds off its host? Is it anti-capitalist? What impact will it have on the market? Those are interesting questions we will explore, later.

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