Most active managers are skilled. Jonathan B. Berk
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. firstname.lastname@example.org
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 ). 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  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 sensitive to past fund performance, despite no strong evidence of persistence.
THE JOURNAL OF PORTFOLIO MANAGEMENT
Copyright 2005 Institutional Investor, Inc.
My objective is to explain these facts and show why they are consistent with a rational and competitive financial market and active managers who have skill and add considerable value. Let’s begin by considering five hypotheses that many investment professionals take on faith: 1. The return investors earn in an actively managed fund measures the skill level of the manager managing that fund. 2. Because the average return of all actively managed funds does not beat the market, the average manager is not skilled and therefore does not add value. 3. If managers are skilled, their returns should persist—they should be able to beat the market consistently. 4. In light of the evidence that there is little or no persistence in actively managed funds’ returns, investors who pick funds on the basis of past returns are not behaving rationally. 5. Because most active managers’ compensation does not depend on the return they generate, they do not have a performance-based compensation contract. At first glance, all five hypotheses appear plausible. In fact, I show that in a model in which rational investors compete with each other for the services of value-adding managers, none of them is true—they are five widely held myths. THOUGHT EXPERIMENT
In Berk and Green , we derive a theory of active portfolio management in an economy in which investors and managers are fully rational. I’ll summarize that theory and show why it implies that the five hypotheses are myths. Imagine an economy with skilled investment managers with differential ability who can generate positive risk-adjusted excess returns. Managers and investors alike know who these managers are. Assume that managerial ability to generate excess returns cannot be effectively deployed...