The following letter is in response to our interview with Ken French, published on June 3, regarding his study, The Cost of Active Management.

Dear Editor:

I enjoyed our interview with Ken French.  As the publisher of a newsletter geared to institutional investors, we have written about French’s study as well.  I thought your readers would be interested in our views on the results of the study and Ken’s comments in your interview.

Immediate benefits of active management 

Institutions have increased their allocation to passive investing significantly over the past 20 years, so the question becomes whether institutions are wising up to high active management fees.  Interestingly, French points to increasing institutional hedge fund allocations as evidence that they are not, in fact, becoming more passive after all:

Advisor Perspectives: Institutions hold a significantly higher percentage of their assets in passive funds, as compared to individuals. As of 2006, DB plans held 31.2%, non-profits held 28.7%, and public funds held 52.7% of their assets in passive funds. Are institutions wiser as to the negative sum consequences of active investing?

French: My initial reaction to the public equity data was that institutions were getting the message. After looking further, however, I am not sure this is the correct inference. For example, much of the explosive growth in hedge funds is driven by institutions. Thus, instead of paying fees of 100 basis points per year for actively managed mutual funds, institutions are paying 425 basis points in hedge fund fees. It looks like many institutions have not really embraced the passive story.

French is right, institutions have not “embraced the passive story.” They have embraced the separate management of active and passive portfolios - of alpha/beta bifurcation.  Indeed, French himself acknowledges that markets are only semi-efficient - opening the door for all kinds of active management opportunities. 

Aggregate benefits of active management 

French doesn’t mince words with his central argument in the paper:

On average, active investors spend 0.67% of the total market cap each year on what, in aggregate, is a futile search for superior returns. If we assume that society will continue to spend the current real dollar cost of active investing forever and that the expected real return on the U.S. stock market is a constant 6.7%, the capitalized cost is 10% of the current value of the market.

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