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A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, Sept. 9. (Michael Nagle/Bloomberg)
A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, Sept. 9. (Michael Nagle/Bloomberg)

Stock-picking professionals are beating the indexers Add to ...

Passive investing is eating the mutual-fund industry, as money floods out of actively managed funds and into index funds and exchange-traded funds. “Passive” typically means two things - diversification and minimal trading. Active funds are supposed to make money by concentrating their investments and taking advantage of good opportunities. The case for passive investing is that active investing is a losing game.

Most finance professors will tell you that active management isn’t worth it. The market is just too efficient - efforts to beat it cost time and money but produce little in the way of extra risk-adjusted returns. Better to ride the average with an index fund or ETF than waste time trying to out-think the crowd.

For individual investors -- folks picking stocks at home with their own money -- the academics are giving very good advice. When retail investors trade, they tend to lose money each time - on average, they’re making bad decisions, and paying trading costs for the privilege of doing so. Only a very small percentage of normal people - perhaps 2 per cent to 5 per cent - have the skill to consistently beat the market average, after adjusting for risk.

Professionals, however, are a different matter. A large number of studies has documented that the typical mutual fund manager really does have the skills to beat the market on average. Now, via finance professors Lubos Pastor, Robert Stambaugh and Lucian Taylor, there is more evidence that professional money managers are very different from their amateur counterparts.

Pastor et al. look at what happens when mutual funds trade. If fund managers have market-beating skill, their trades should come from spotting real opportunities instead of mirages, so they should make higher returns just after an unusually large burst of trading -- assuming, of course, that their trades pay off within a year. Since most money managers are judged on annual performance, that’s probably an OK assumption.

In general, trading isn’t correlated with higher or lower returns. That means that you can’t make more money by picking a fund with higher or lower trading (sorry!). But for each specific fund, higher-than-average trading is followed by higher-than-average returns. That means that although not all trading is based on good opportunities, a lot of it is. When there are chances to beat the market, money managers tend to see them and take them.

Most of these opportunities are not the kind of thing that finance professors could observe directly in the data (if they were, more professors would be managing funds). But Pastor et al. are able to observe a few good trading decisions directly. Finance researchers know about a number of anomalies -- signals that assets are mispriced. Pastor et al. find that when these signals are stronger, fund managers trade more and earn better returns -- this indicates that the professionals know about and exploit these market inefficiencies.

So money management skill is real. But does this mean that active management is underrated, and the stampede into index funds and ETFs is overdone? Maybe, maybe not. Pastor et al. also find two very important reasons to stay away from active management.

The first reason is diminishing returns -- a phenomenon many investors know as crowding. The market isn’t perfectly efficient, but there’s a limit to the amount of money that can be made. Pastor et al. find that smaller funds are better at making advantageous trades, implying that there are decreasing returns to scale. Even more importantly, they find that larger funds have a weaker relationship between trading and performance -- meaning that the less money you manage, the easier it is to find profitable investments.

The second reason is fees. Mutual funds with better trading ability tend to charge higher fees, which makes sense. But the overall level of fees in the industry is so high that even though the managers have skill and can beat the market, it’s usually not enough to justify the prices they charge for that skill.

So although there is real value in active management, the industry is probably too big. Gigantic funds are finding it harder to spot profitable trades. And most active funds charge investors too much. Therefore, the exodus from active management still makes sense. Eventually, if it continues, active managers will shrink in size and drop their prices, and balance will be restored.

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Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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