Practical analysis for investment professionals
26 July 2016

Is Active Management Dead? Not Even Close

Is Active Management Dead? Not Even Close

Several years ago, I interviewed C. Thomas Howard of AthenaInvest to learn more about his firm’s unique implementation of behavioral finance. This turned out to be one of the best performing pieces of content Enterprising Investor has ever run. But it isn’t just AthenaInvest’s originality that’s so compelling, so too is its strong performance.

Howard also has an interesting pedigree as a recovering and almost lifelong finance professor turned practitioner. Recently he has focused his attention on another problem: determining whether or not active management is dead. In addition, he is dedicated to uncovering ways active managers can improve their performance — and he has the academic chops to back up his story.

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CFA Institute: Is active management dead?

C. Thomas Howard: There is a strong drumbeat to this effect within the industry. The growth of index funds, at the expense of active equity funds, reinforces this notion. But active management is alive and well within the equity mutual fund industry. In a recent comprehensive study, I found that as many as 90% of active equity managers are superior stock pickers, a result that runs contrary to much conventional wisdom.

The reason so many active funds end up underperforming is not for lack of skill, but is the result of subsequent portfolio management decisions. Among other things, funds that asset bloat (i.e., become excessively large), benchmark track, and over diversify, destroy the excess returns generated via superior stock picking. They do these things for rational reasons. They grow large because they are compensated based on assets under management (AUM) fees, they manage to the benchmark (which leads to closet indexing) because consultants and platforms demand it in order to be considered for new flows, and they over diversify because emotional investors expect a lot of stocks in a portfolio. In my study, I’ve termed these performance impediments collectively as “portfolio drag,” a bane within the industry.

Given the opportunity to manage portfolios based on their preferences, the vast majority of fund managers would deliver superior performance to investors. Those funds that don’t asset bloat, benchmark track, or over diversify do generate superior returns. It is into these truly active funds that investors should put their money. But alas, the industry is structured to incent funds to become closet indexers, the very value destroying entities investors should avoid.

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What are the factors leading to this fiction?

Many academic studies find the average equity mutual fund underperforms, a conclusion with which I agree. Many contend this is due to a lack of skill, a conclusion I do not agree with. In my studies, I find widespread skill, but I also find widespread portfolio drag which leads to the underperformance.

Making matters worse is the challenge of correctly identifying truly actively managed funds. With so many funds managing assets to deliver benchmark performance rather than alpha, while charging actively managed fees, the mix of fund managers skews performance results lower since their stated objective of growth, for example, really means “growth that mirrors the benchmark.”

Another factor when selecting a fund is the focus on fees. The funds with the largest asset bloat, thus the greatest portfolio drag, will have the lowest fees, but will be unable to generate superior returns due to size. As they say, it is hard to sneak around with $50 billion. Include the US Department of Labor’s fiduciary rule and robo-advisers, and there is ever more emphasis on costs. The availability bias plays a major role here, as information on fees is highly accessible while skill is not.

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Let’s drill down into those adjunct methodologies: What is wrong with them?

There are a couple of aspects of statistical testing that contribute to the conclusion that skill is rare.

First, many studies focus on life of fund performance. That is, in order to be considered a skilled fund, one must outperform over the full life of the fund. However, even if the fund is skilled over an extended time, and my research reveals that skill remains fairly constant over time, performance will decline as portfolio drag increases with fund age. In other words, fund asset bloat, benchmark track, and overdiversifying increases as funds grow older. The result is that the “life of fund” performance measures dramatically understate the pervasive skill within the industry.

Second, the focus is often on individual fund rather than on collective across fund through time performance. There is so much noise in equity markets that it is virtually impossible for a skilled fund to generate statistically significant performance. For example, a fund generating a 4% annual alpha needs over 30 years of such performance to be statistically significant. Making things worse, age-driven increases in portfolio drag, given fund growth, make such a finding even more problematic.

A related issue is that tracking error is the standard error used for estimating significance. But in order to generate superior performance, the fund must look different from its benchmark, thus experiencing tracking error which, in turn, reduces the chance a study will find significant performance.

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How would you change them?

Based on my previous response, I conclude standard statistical tests are stacked against finding individual fund skill. This is a frustrating situation for the many skilled managers within the industry. As a result, the best that can be done is to identify collective, statistically significant performance after adjusting for portfolio drag. I present such an approach in my research, “Why Most Equity Mutual Funds Underperform and How to Identify Those That Outperform.” I find that 90% of active equity funds are skilled, with 80% able to more than cover their fees. Skill is not scarce, it is pervasive within the industry.

I also produce other results that run contrary to conventional wisdom. The best funds, those that are skilled with low portfolio drag, charge higher fees and are attracting new fund flows. It is reassuring that these truly active equity funds are bucking the trend of net outflows.

Sorting funds based on fees leads investors away from the best funds. I find it better to sort first on low portfolio drag, and then on fees.

There is a related issue regarding industry credentialing. Organizations providing certification for investment analysts, such as CFA Institute and Investment Management Consultants Association (IMCA), among others, send mixed messages to the industry. On the one hand, they provide education and credentials for buy-side and sell-side analysts. Studies show that these two groups add value to the investment process. However, these organizations also credential consultants and platform analysts, which studies show destroy value in the investment process due to the constraints they impose on active managers. It is not overstating the case that credentialed consultants and platform analysts are major contributors to the collective dismal performance of active equity managers.

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It would be nice to see credentialing organizations add value rather than destroy it in the investment process. This can be done by developing education programs that encourage all analysts to help identify profitable investment opportunities, rather than having a significant portion of them impose arbitrary constraints on active managers.

Such changes would help the industry transition to a new equilibrium in which there are only two broad categories of equity funds: truly active equity funds and low-cost index funds. This transition is already well underway with the rapid growth of index funds and ETFs at the expense of active funds, accompanied by an index fee race to the bottom. Outflows from the closet index funds helps to narrow the consideration set.

These beneficial tectonic changes should be accompanied by a new framework for encouraging truly active equity funds. My research suggests that such funds have AUM less than $1 billion; an R-square with a benchmark of between 0.6 and 0.8; and relative portfolio weights greater than 30% across their top 10 high-conviction positions.

The new equilibrium will result in an industry of truly active equity along with low-cost index funds, with nary a closet indexer in sight.

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Talk to me about the additional fiction that active management is a zero-sum game.

A strongly held belief within the investment industry is that stock picking across active equity funds must be a zero-sum game. Such an assertion is true for the stock market as a whole, as stock picking must have as many losers as winners. But this does not have to be the case in every market segment.

The US stock market has a current total market value exceeding $38 trillion. Active US equity mutual funds hold $3.6 trillion, about 9% of all equities. So it is entirely possible for the average stock held by funds to outperform at the expense of the other 91% of the equity universe.

Arguing that stock picking among equity funds must be a zero-sum game is akin to arguing it is impossible to drown in a lake of average depth of three feet. That lake may have pockets 20 feet or more deep. Both represent indefensible statements.

In particular, this study estimates that the average stock held by active equity mutual funds earns an alpha of 1.3%, confirming that mutual funds do earn superior returns. Indeed, this must be the case in order for equity funds to cover their fees and, in turn, earn a near-zero collective alpha.

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What research is there that supports your point of view?

There are two long and growing lines of research supporting the view that superior stock picking skill is the rule rather than the exception. The first finds truly active equity funds outperform. In these studies, the level of fund activity is measured by tracking error (the higher the better), benchmark R-square (lower the better), active share (the higher the better), and portfolio weighting best idea stocks (the larger the better), among other measures.

These results raise the question of why simply being more active allows the fund to outperform. If managers lack skill, as is so widely believed, then simply taking more high-conviction positions, for example, will not generate better performance. So, it must be the case that many managers are skilled stock pickers. This is what the second line of research finds.

Using a variety of approaches, a series of studies found that best idea stocks outperform other low conviction stocks in a portfolio, as well as outperform the fund’s benchmark. Thus, being truly active and having skill reinforce one another as the source of superior performance.

For those interested, I provide an extended discussion for both of these research streams in this article.

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What is AthenaInvest doing to compete in this environment?

AthenaInvest consistently pursues narrowly defined equity strategies and takes high-conviction positions. We keep portfolio drag to a minimum. Our focus is on building long-horizon wealth and as such, we do not attempt to manage short-term volatility and drawdown, and thus work with our clients to help them avoid making value-destroying decisions based on the emotions triggered by such events.

Measurable and persistent behavioral price distortions are identified by means of extensive research which is embedded in the academic literature. Once identified, we then design and manage a portfolio, harnessing the distortion. We refer to this approach as Behavioral Portfolio Management.

Over the years, our equity portfolios have been among the top performers in their respective categories, and our AUM has grown rapidly. Our success is confirmation that superior performance and AUM growth is possible in today’s equity markets when you are a truly active equity manager. And, it is consistent with our research and other academic research regarding active management.

Active management is alive and well within the equity industry!

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

25 thoughts on “Is Active Management Dead? Not Even Close”

  1. Joyce Matthews says:

    Their one remaining ETF DIVI is down 18% over the past year. Their other ETF (a short fund) shut down last year. I’d say the jury is still out… way out.

    1. Hi Joyce,

      Thanks for your comments. And what is your opinion of the research that is extensively featured in this interview?

      Yours, in service,


    2. Tom Howard says:

      We manage nearly $300 million with DIVI representing $7 mil of that. Over the collective 30 years that we have managed our high conviction stock portfolio (Pure), High Dividend Equity, and Global Tactical ETFs the average AUM weighted alpha has been in the 6% neighborhood.

      DIVI was caught in the worst dividend inversion in 20 years in 2015 (low dividend stocks outperforming high dividend stocks). So far this year it is the top performing fund out of the 1,183 funds in its Morningstar peer group, beginning the recovery from this inversion with a 14% YTD return.

      But the point is our equity portfolios experience considerable tracking error and we are proud of that since that is what produces long-term success.

      By focusing on the performance of a single fund over a short time you highlight the very problem plaguing the industry. Do you really focus on short-term performance in making your investment decisions? If you do then you will underperform over the long run since you will very likely gravitate to closet indexers.

      Research shows a fund that consistently pursues a narrowly defined strategy, takes high conviction positions, and experiences considerable tracking error outperforms over the long-run. Often the benefits of such an approach show up after 5 years and are well established by 10 years.

      1. Joyce Matthews says:

        I appreciate your reply and the interview preceding it. However, readers need to understand the potential volatility (not to be confused with risk) of your approach. Taking DIVI as the only truly public and easily accessed example, it dropped from roughly $26 shortly after launching down to $13 earlier this year! That was a drop of 50% (and we all know you need a 100% rise to break-even after a 50% drop). The fall was actually more than the general market dropped in the GFC! As such, the 15% rise YTD is only a small fraction of the 100% bounce (from the bottom) that will be needed to make a new high. Indeed, the holders of DIVI may well need that 10 year commitment to see it establish its superiority. Volatility may not be the same as risk, but explaining that to someone with a paper loss of 50% is a thankless task.

  2. Tom Howard says:


    We have great respect for advisors who have the very valuable and difficult job of dealing with client emotions. The truly active funds that are capable of generating superior returns stir up strong emotions. So the choice becomes being emotionally comfortable in the short-run versus generating long horizon wealth. This is a tough choice for most and in the vast majority of cases the decision is more comfort and less wealth. Obviously each investor is free to make the decision that is right for them.

    But the low emotion solution should not be imposed on active equity managers. This is what the industry does by imposing emotion reducing constraints which result in poor performance. Then they claim that funds have no stock picking skill. Better to let funds be truly active, thus providing superior returns, while managing emotions at the overall client portfolio level.

    This means not focusing on short-term individual fund and stock performance. This is the challenge advisors face with their clients. They naturally gravitate to the lowest level and cannot imagine how their portfolio can do well holding a stock that has dropped by more than 50%. But indeed this is the nature of high performing portfolios.

    So active management is alive and well save for the emotional demands of the industry and investors.

    Thanks for your thoughtful comments and I hope you can convince your clients to get past their emotions and build long-term wealth. As you know, this can mean 100s of thousands if not millions of dollars of additional wealth.

    Be wealthy and do good!


  3. Eli Tal says:

    Do you have any products with a public performance record other than DIVI?



    1. Tom Howard says:

      We run multiple SMA strategies that have been recognized for long-term outperformance. The exception has been our dividend portfolios which have been down in the short term along with everyone else in the category, but they have rebounded strongly this year. Information is available on our website Here are the SMA strategies and the fact sheets can be found at our website

      • Pure Valuation – Concentrated All Cap Equity
      • Dividend Income – Concentrated High Dividend
      • Global Tactical ETFs – Tactical Market Rotation
      • Managed Equity – Behavioral Equity Portfolio (Multi-Strategy)


  4. Hi! Jason, that majority of fund managers are skilled & how not managing risks of portfolio drag, not giving enough weight to conviction buys impacts returns. Makes this article a gem. Well done.

  5. Bill Brasky says:

    (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

    (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar
    William F. Sharpe-
    The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9

    You can get as cute as you want with how you define passive and active management attempting to avoid these truths, but they are self evident, and those who fail to acknowledge them are simply self interested.

    1. Hello Bill,

      Thank you for taking the time to respond to this article. Your readership is valued by each of us at CFA Institute!

      Yours, in service,


  6. Tom Howard says:

    Apparently you did not read (or did not like) my answer to Jason’s interview question “Talk to me about the additional fiction that active management is a zero-sum game.” In a nutshell, I said while it has to be zero sum over the entire stock market, it does not have to be the case within each segment of the market (more detail in my interview response).

    The fact that the vast majority of active equity managers are skilled stock pickers means that if the fund avoids asset bloat, benchmark tracking, and overdiversification (what I call portfolio drag), there is an excellent chance the fund will outperform.

    One of the interesting research results is that the top 20 or so relative weight holdings outperform while the lower relative weight holdings underperform. In one of the stranger twists, we find that a fund’s high conviction stocks do well at the expense of the low conviction stocks in the same portfolio. This is a consequence of imposing drag on the portfolio after purchasing the manager’s favorite stocks.

    As I also noted, Wermers finds that the average stock held by a fund outperforms by about 130 bp , which is roughly equal to the average fees charged by funds. As a takeoff on Sharpe’s comment you quoted, in the world of active equity mutual funds, the average stock held outperformance equals average fees, leading to near zero alpha across funds. That is, skill is widespread but its benefits are wiped out by portfolio drag and fees.

  7. James Tharin says:

    It’s so refreshing to hear from the active side of the active passive debate. I sincerely hope that Enterprising Investor will consider being more balanced in their views on the issue. This is a great start.

    1. Hi James,

      Thank you for your comment. I write routinely about ways that active managers can improve their returns (see my: Skills That Separate You As An Investment Manager series), as well as some of the reasons why they underperform (see my: Alpha Wounds series).

      Yours, in service,


      1. James Tharin says:


        Thanks for your response. I stand corrected. Please disregard my previous comment.

        Best regards,

        James Tharin, CFA

  8. Savio Cardozo says:

    Hello Jason
    Just catching up on this post – there is one thing mentioned called high conviction investing that caught my attention mainly because I recently met a portfolo manager who has been very successful at doing just that – investing in high conviction companies.
    In my career as a management consultant I have had the good fortune of looking at companies from the inside – the best way to summarize this experience is that in most companies the bulk of the IP walks out of the door every evening.
    From an investor’s point of view this seems like a tenuous way of predicting the future value of the company five or ten years from today (think Kodak or Sony or many of the names of the past that have seen their best and brightest walk out).
    When you have some time please let me know which company (ies) truly value their employees (some tech companies do but Steve Jobs was fired from Apple).
    As we get close to the annual hoopla called performance reviews perhaps we should pause to rethink, as investors, are their employees really engaged or is this HR hype?
    I have had the experience of running into your watch touting executive more times than I would have liked so I think high conviction investing will only work if the investor is actively involved in the management of company, not at the board level (as is the norm) but having eyes and ears on the shop floor.
    My two cents for the cause.
    And a pleasant long weekend to you

    1. Hello Savio,

      As always, thank you for taking the time to comment, and for reading The Enterprising Investor. I think your points about intellectual property are logical and flow naturally from your assumptions. So within that context they are tough to refute. However, just off the top of my head I can think of several other contexts in which your logic does not entirely hold. The first is to point out that intellectual property held in the form of patents is the property of the company. Patents do confer a continuous advantage. The second is that intellectual property is also contained in business plans and business models. That is, a better thought out plan or model trumps all others. Case in point: Uber is a superior business plan and model to that of any local taxi company. Whether Uber experiences turnover or not has little effect on this superior business. Next, execution of business plans and models is also a part of that ephemeral thing known as company culture. Company culture can persist even beyond individual employees or groups of employees and can even transcend time and place.

      Last, and totally separately, high conviction is the denominator of the portfolio manager, not of the company in which an investor might place capital. What Tom is arguing here is that portfolio managers may examine thousands of companies and their securities, but that they only have a high degree of confidence in 10-30. That conviction may come from their deep understanding of the business, its model, its people, its executives, and/or its price. Unfortunately, the active management profession has evolved so that keeping a portfolio just to your high conviction names is a tough decision to make. First, there are the investment industry adjuncts that scream bloody murder that you would dare concentrate a portfolio, would possibly have style drift, would possibly have tracking error, and so on. Next, your fund company executives would be irritated if you turned away assets under management because scale is how asset managers get paid, rather than via returns. Yes, returns can grow AUM, but they are a lot harder than simply saying yes to new money that flows your way. I could go on, but I know that you understand the structure of the industry well.

      Big smiles sent up north!


      1. Savio Cardozo says:

        Hello Jason
        Thank you for your usual thought provoking responses.
        I suppose my bias against buy and hold (you may recall our exchanges on this blog about who is the shareholder – the short term or long term buyer) is putting blinkers on my ability to fully appreciate fundamental analysis and investing.
        Thanks again.
        Kind regards and a pleasant weekend
        PS I once bought and held on to Nortel which had patents coming out of its wazoo – I think I still have those worthless stock certificates somewhere.

        1. Hello Savio,

          As always you have provided reliably excellent commentary. Nortel was exceptionally tempting back in the day…especially for Canadians. Please tell me that Blackberry was not also among the buys and holds.

          Yours, in service,


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