5 Myths of Active Portfolio Management
Five Myths of at Active Portfolio Management m r
Most active managers are skilled. Jonathan B. Berk
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JONATHAN B. BERK is the Harold Furst associate professor of management philosophy and values in the Haas School of Business at the University of California at Berkeley. berk@haas.berkeley.edu
roponents of efficient markets argue that it is impossible to beat the market consistently. In support of their view, they point to the evidence that active managers as a group do not beat the market. Their conclusion is that these investment professionals do not have the skills necessary to pick stock or time the market. Yet if this argument is correct, why do we have active portfolio managers at all? Even more puzzling is managers’ level of compensation. One of the first principles any student of microeconomics learns is that in a competitive market (which the capital markets surely are), people can earn economic rents only if they have a skill that is in short supply. If active managers cannot pick stocks or time the market, what rare skill do they have that makes them among the highest paid members of society? Even people who allow for the possibility that some managers have skill have been hard pressed to find evidence of this skill in the data. Beyond a year, there is little evidence of performance persistence—managers who do well in one year are no more likely to do well the next year (see Carhart [1997]). This fact is widely interpreted as evidence that the performance of the best managers is due entirely to luck rather than skill (and is thus not repeatable). As Gruber [1996] notes, the behavior of investors is just as puzzling. Why do investors continue to invest with active managers in the face of this evidence? Yet investors chase returns; a good year induces an inflow of capital, and a bad year induces an outflow of capital. The flow of capital into and out of actively managed mutual funds is
Most active managers are skilled. Jonathan B. Berk
I
is t
ill
ga e
to l
ep r
od r
ce u
th
JONATHAN B. BERK is the Harold Furst associate professor of management philosophy and values in the Haas School of Business at the University of California at Berkeley. berk@haas.berkeley.edu
roponents of efficient markets argue that it is impossible to beat the market consistently. In support of their view, they point to the evidence that active managers as a group do not beat the market. Their conclusion is that these investment professionals do not have the skills necessary to pick stock or time the market. Yet if this argument is correct, why do we have active portfolio managers at all? Even more puzzling is managers’ level of compensation. One of the first principles any student of microeconomics learns is that in a competitive market (which the capital markets surely are), people can earn economic rents only if they have a skill that is in short supply. If active managers cannot pick stocks or time the market, what rare skill do they have that makes them among the highest paid members of society? Even people who allow for the possibility that some managers have skill have been hard pressed to find evidence of this skill in the data. Beyond a year, there is little evidence of performance persistence—managers who do well in one year are no more likely to do well the next year (see Carhart [1997]). This fact is widely interpreted as evidence that the performance of the best managers is due entirely to luck rather than skill (and is thus not repeatable). As Gruber [1996] notes, the behavior of investors is just as puzzling. Why do investors continue to invest with active managers in the face of this evidence? Yet investors chase returns; a good year induces an inflow of capital, and a bad year induces an outflow of capital. The flow of capital into and out of actively managed mutual funds is
References: Ambachtsheer, Keith P. “Active Management That Adds Value: Reality or Illusion?” The Journal of Portfolio Management, 21 (1994), pp. 89-92. Berk, J.B., and R.C. Green. “Mutual Fund Flows and Performance in Rational Markets.” Journal of Political Economy, 112 (2004), pp. 1269-1295. Carhart, M. “On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), pp. 57-82. Gruber, M.J. “Another Puzzle: The Growth in Actively Managed Mutual Funds.” Journal of Finance, 51 (1996), pp. 783-810. To order reprints of this article, please contact Ajani Malik at amalik@iijournals.com or 212-224-3205. SPRING 2005 THE JOURNAL OF PORTFOLIO MANAGEMENT 31 Copyright 2005 Institutional Investor, Inc.