A Simple Case For Active Portfolio Management

Over the last 30 years, a lot of empirical research has been conducted regarding successful active portfolio management and persistence in returns. Most of these studies began after the CAPM model was introduced, which of course provided the fundamental framework for performance analysis of managers. So are the top managers skillful, or just lucky? Moreover, does their performance persist over time? These are some of the questions addressed by such empirical studies. In the end, most of these studies give mixed results at best - some claim it is possible to achieve excess returns consistently, while others claim it is not.

Before going any further, it may be a good idea to differentiate between active and passive management styles. A passive management strategy would entail making very few decisions thus allowing for low transaction costs. Investing in an index fund would be considered a passive strategy. Conversely, an active management strategy involves making many calculated decisions and investments with the final goal of outperforming a benchmark index, such as the S&P 500. This style of management tries to exploit any potential arbitrage opportunities to make a profit.

A major case against active management is the Efficient Market Hypothesis, which basically states that markets are completely efficient because one cannot have superior information than another, thus arbitrage opportunities do not exist. I may not have empirical data of managerial performance over time, but I think it is very obvious such arbitrage opportunities exist and that active management can indeed be profitable. My very simple argument is this: if active management did not yield returns in excess of the benchmark indices, what explains the existence and profitability of the many hedge funds across the US? These active managers must be doing something right. In addition, I think investors do not always act rationally. For example, I know there are many people that invest in a particular asset simply because others are investing in it - this does not seem very rational. This may allow for inefficiencies in the market to occur, creating arbitrage opportunities.

Of course, the hard part is finding these inefficiencies in the market, and exploiting them to yield excess returns consistently.