There are many well-known anomalies in finance. The most notable of these anomalies include the momentum effect, the low-volatility effect (in which high-volatility stocks produce lower returns on average than low-volatility stocks) and the poor performance of IPOs, penny stocks, stocks in bankruptcy and small growth stocks with low profits.
But perhaps the biggest anomaly is why the majority of investors—both individual and institutional—continue to favor actively managed funds when there is an overwhelming body of evidence demonstrating that, even though active management is a game that’s possible to win, the odds of outperformance are so poor that it’s not prudent to try.
That evidence, and the logic associated with it, is why author Charles Ellis called active management the loser’s game. In his 1998 book, “Winning the Loser’s Game,” Ellis explained that the surest way to win a loser’s game (such the craps table or the roulette wheel in a Las Vegas casino) is to choose not to play.
It’s also why Warren Buffett offered this advice in his 1996 annual letter to Berkshire Hathaway shareholders: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
Explaining Active Management’s Popularity
Ron Bird, Jack Gray and Massimo Scotti—authors of the 2013 study, “Why Do Investors Favor Active Management To the Extent They Do?”—sought to understand why investors place such a large proportion of their funds with active equity managers, given the discouraging evidence on active management’s ability to add net value.
One obvious explanation for favoring active management is that investors may be unaware of the peer-reviewed evidence on the very low probability of net outperformance and successful manager selection. They may also be unaware of certain biases in the data, such as survivorship and incubator bias. And lack of knowledge can be exacerbated by media advertising, which favors active management.
To further examine this issue, the authors conducted two online surveys, one of chief investment officers (CIOs) of predominantly large Australian pension funds and another of asset consultants. They found that, in general, CIOs and consultants do attempt to make decisions in a rational, evidence-based framework. However, their attempts are undermined by other forces. Despite the evidence, 86 percent, 82 percent and 77 percent of small, medium and large plan assets, respectively, were actively managed. And half of all plans were completely actively managed.
Following is a summary of the authors’ findings: