The story of active management under-performance is retold on a monthly, quarterly, and annual basis. And it appears that investors are listening, based on the wall of money that has flowed, and is continuing to flow, from active to passive funds. In this context, I mean “passive” not only to be index tracking funds, but also funds like those offered by Dimensional Fund Advisors, who utilize broadly diversified portfolios to implement their investment strategies.
Much attention has been focused on the cost of trading, and the cost of management, to explain the chronic underperformance of active managers in most major equity asset classes. But a recent Bloomberg article titled The Math Behind Futility recalls an academic paper written in the late 90s, by Richard Shockley of Indiana University, which offers a mathematical explanation of why costs alone do not explain the totality of underperformance. The underlying cause is something called skewness, or in this context, the tendency of a minority of stocks within an index to provide outsize returns. Because active managers tend not to invest in all of the stocks in an index, omitting stocks with positively skewed returns amounts to a “death sentence for anyone who gets paid for beating a benchmark.”