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Active managers play a critical role in price discovery. We have traditionally had, and definitely still have, far more active managers than needed, but some n

by nugget 10y ago

Active managers play a critical role in price discovery. We have traditionally had, and definitely still have, far more active managers than needed, but some number of them must survive in order to have a healthy market. Sometimes we lose sight of this in the (well-deserved) celebration of passive index investing. I'm interested in a few questions that only time will answer. First, what % of the market needs to be active rather than passive in order for healthy price discovery to occur? Is there an efficient frontier or stabilization point? Second, as passive indexes become the vast majority of public equity dollars, are there more opportunities for smart active investors to out-perform? (Given enough passive indexes as counterparties, it's theoretically possible for every remaining active manager to out-perform the market.) Third, in aggregate, what % of out-performance (if any) will active managers be able to take, as fees, in the future? (And what does it say about human psychology if it's >100%.)

jessriedel 10y ago
In the ideal case, the answer to your second questions seem to be obviously "yes"; the market in active managers will hit an equilibrium where their salary is paid by the additional info they bring. However, it seems clear from the current situation that the market is far from ideal since there have been too many active managers for decades. Whatever it is that allows them to persist (human overconfidence, salesmen, principal-agent problems) has not been eliminated, even if "word has gotten out" so that investors have began to develop a partial immunity against them. Knowing exactly where the new equilibrium will be requires a detailed understanding of that mechanism, which I don't think anyone has.
dragontamer 10y ago
While I agree with you that price discovery is useful... the facts of the situation mean only one thing: Active investing will decline until active investing is profitable. The price of stocks is dominated by human emotions in the short term after all (ex: Enron cooked the books as early as 1996... but didn't go bankrupt till 2001). Holding onto a "short" position for 5+ years is basically unheard of, especially in the context of a Stock whose price is skyrocketing. (You probably would have been margin-called during that runup). How many people would trust their "active investment manager" avoiding a hugely successful company with huge income growth? A quickly stock price and a good dividend? http://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf http://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf The fact is: even with perfect knowledge about which companies are good and bad (Perfect 20/20 hindsight), its still incredibly difficult to make cohesive arguments for or against particular companies.

by nugget 10y ago

jessriedel 10y ago

In the ideal case, the answer to your second questions seem to be obviously "yes"; the market in active managers will hit an equilibrium where their salary is paid by the additional info they bring. However, it seems clear from the current situation that the market is far from ideal since there have been too many active managers for decades. Whatever it is that allows them to persist (human overconfidence, salesmen, principal-agent problems) has not been eliminated, even if "word has gotten out" so that investors have began to develop a partial immunity against them. Knowing exactly where the new equilibrium will be requires a detailed understanding of that mechanism, which I don't think anyone has.

dragontamer 10y ago

While I agree with you that price discovery is useful... the facts of the situation mean only one thing: Active investing will decline until active investing is profitable. The price of stocks is dominated by human emotions in the short term after all (ex: Enron cooked the books as early as 1996... but didn't go bankrupt till 2001). Holding onto a "short" position for 5+ years is basically unheard of, especially in the context of a Stock whose price is skyrocketing. (You probably would have been margin-called during that runup). How many people would trust their "active investment manager" avoiding a hugely successful company with huge income growth? A quickly stock price and a good dividend? http://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf http://picker.uchicago.edu/Enron/EnronAnnualReport2000.pdf The fact is: even with perfect knowledge about which companies are good and bad (Perfect 20/20 hindsight), its still incredibly difficult to make cohesive arguments for or against particular companies.