Exposing a False Claim about Active Managers

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This article originally appeared on ETF.COM here.

While I was performing my daily perusal of the SSRN website in order to review the latest studies on investing, I came across a paper by Atanu Saha and Alex Rinaudo of Data Science Partners, “Actively Managed Versus Passive Mutual Funds: A Horse Race of Two Portfolios,” which was written in May 2017 but only recently posted.

Given the subject, I read the abstract, which had, at least for me, a very surprising conclusion. It stated: “This paper demonstrates that the average investor would be better off by following a readily-implementable strategy of investing in a portfolio of the five largest active funds in U.S. equity, fixed income and international equity asset categories than investing in a corresponding portfolio of passive index funds. The active-fund-portfolio outperforms not only in terms of average returns, but also in risk-adjusted returns, providing far greater downside risk protection than the passive fund portfolio. This paper has important implications because its findings question the ‘wisdom’ of index investing, which has been receiving considerable attention in the financial press in the recent years.”

Lopsided race

To create their horse race, the authors constructed portfolios across three broad asset classes: domestic stocks, domestic bonds and international stocks. They took the five largest active funds and the five largest passive funds in each category and reconstituted the portfolios annually. The study covered the period 1996 through 2015.

Saha and Rinaudo found that, in addition to the portfolios of the five largest active funds outperforming the portfolios of the five largest passive funds in each of the three broad asset classes, they also outperformed the average active fund.