Many of us would have heard of the argument of the efficient market hypothesis, that the average actively managed fund will underperform a passive fund. For those who might not know, an actively managed ETF fund is one where managers hand-pick investments seeking the best return, while a passive ETF is one where they keep management fees low by blanket buying whole classes of assets. Many argue that skilled managers can find the best investments, while others argue the average manager will get the average return of the market, and a passive fund will get the same minus the fees.
To be fair, the fees on some funds get pretty ridiculous. I found “fund of funds” with costs of over 10% and many exotic strategy ETFs have expense ratios of 2-3%. Meanwhile, the average passive fund has an expense ratio of 0.03%, while some have no charge at all (they make all their money through stock lending and they're limited to block trading the most liquid stocks). The average actively managed, however, has an expense ratio of 0.75%-2% and for this test I have to exclude exotic products like volatility ETPs, leveraged funds, and bear funds.
However, all else being equal, I expect the long term return of the average actively managed fund to lag the average passive fund by 1-2%. This isn't a viable trading strategy as that is below the return of government bonds and doesn't take into account the cost of trading and cost to borrow shares. Also, a lot of the worst offenders in active management are tiny funds where there are few if any available shares to short.
However, to show the folly of a lot of investors out there, I open my paper trading account and I short the 20 funds with the highest expense ratios and go long on the 20 with the lowest expense ratios. Weights are completely arbitrary as I'm too lazy to balance the whole thing out, instead I have a paper position of 100 in each and simply added to the smallest position until the portfolio was market neutral.
Complications to this test is that actively managed firms are overweight on technology, small caps, and high-growth stocks while passive funds are overweight on large caps and index-listed stocks (no private equity in passive funds). There are small-cap passive ETFs in this test, but a lot of these funds all hold the same S&P 500 listed stocks. This means this portfolio is overall short on growth, innovation, and private equity.
Another complication is during times of great overall market performance, like during the quantitative easing of 2020-2021, there is little room for active managers to find superior deals. However, during times of high volatility and low overall returns like in 2022, there's many opportunities for a truly skilled manager to show themselves.
This test certainly won't break the market. It will only show how silly a lot of people are by paying a premium to have someone else pick their investments for them.
Leave a Reply