The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management

The debate over the value of active portfolio management has often centered on whether the average active manager is capable of producing returns that exceed expectations. We argue that a more useful way to frame this issue is to focus on identifying those managers who are the most likely to generate superior risk-adjusted returns (i.e., alpha) in the future. Using a style-classified sample of mutual funds, we document several tractable relationships between observable fund characteristics and its future alpha, most notably the tendency for performance to persist over time. While median managers produce positive risk-adjusted performance approximately 45% of the time, we document a selection process that improves an investor’s probability of identifying a superior active manager to almost 60%. We conclude that there is a place in the investor’s portfolio for the properly chosen active manager. Few topics have generated more engaging discussions between investment professionals than the debate over active versus passive portfolio management. The case for active management—which can involve either the selection of individual securities or tactical adjustments to the asset classes in an investor’s long-term strategic allocation—is typically rooted in the belief that it is possible to produce superior investment performance than could otherwise be obtained by simply matching market-wide trends. Conversely, the case for passive (or index) investing—buying and holding welldiversified collections of securities having the desired risk exposure—rests on the notion that active managers have not proven themselves capable of consistently outperforming the relevant benchmarks over time, particularly when transaction costs and management fees are taken into account. There is substantial evidence to support both positions. Dating to the work of Sharpe (1966) and Jensen (1968), who find that active equity managers who produced superior performance in one period were equally likely to generate superior or inferior performance in the next, for many years the predominant academic view was that attempting to actively manage an investment portfolio was a value-decreasing proposition. Mirroring this finding has been the rapid development of the market for indexed investment products, such as index mutual funds and exchange-traded funds. More recently, however, academic research has begun to embrace the notion that active managers can add value to their investors. For instance, Brown and Goetzmann (1995)