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george athanassakos

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

'Canada's active fund managers are missing their benchmarks" cries a recent article in The Globe and Mail. According to the article, this year only 39.62 per cent of actively managed equity funds outperformed the S&P/TSX composite. The number falls to 23 per cent over the past five years.

My reaction to articles like this is "here we go again." As typically is the case, active portfolio managers get no respect, not only in the media but also in academia. If markets are efficient, and most academics believe so, then fundamental analysis and active portfolio management add no value to a portfolio. But are markets efficient?

I have written about my support for active portfolio management before, but it is difficult to get my message across.

My view has always been that active portfolio managers underperform not because of lack of stock-picking abilities, but rather because of institutional factors that force them to overdiversify.

In my experience, the average fund manager is more concerned with losing his job or assets under management than doing the right thing. As a result, many managers don't really try to pick stocks. They become closet indexers, or they diversify indiscriminately to make sure they never stray too far away from the crowd. This is the safest thing to do. And, of course, a closet indexer can never outperform; in fact he will underperform when we account for management expenses.

Most of the discussion in the media and finance courses with regard to active portfolio management relies on old academic studies that naively looked at the average equity mutual fund. However, more recent academic research has disaggregated mutual funds and has better focused on what active managers (non-closet indexers), such as value investors, actually do.

Marcin Kacperczyk, Clemens Sialm and Lu Zheng published two articles in the Journal of Finance in 2005 and 2007 that examined whether skilled managers exist. The researchers studied about 1,700 actively managed U.S. funds from 1984-1999 and 1993-2002. They found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing.

The notion that less is more when it comes to diversification is what value investing and active portfolio management is all about. Portfolio concentration flies in the face of modern portfolio theory, but it has the blessing of John Maynard Keynes, the famed economist.

"The right method in investment is to put fairly large sums into enterprises which one thinks one knows something about," he wrote.

Martijn Cremers and Antti Petajisto, in a 2009 Review of Financial Studies paper, introduced a new measure of active portfolio management, referred to as active share. This is the share of portfolio holdings that differ from the benchmark index holdings. They found that, between 1968 and 2001, the U.S. funds that deviated significantly from the benchmark portfolio outperformed their benchmarks both before and after expenses.

Again, this comes as no surprise to value investors.

However, the strongest evidence against market efficiency and in support of active portfolio management comes from a just released study at UCLA titled Fundamental Analysis Works co-authored by Sohnke Bartram and Mark Grinblatt. The authors show that prices do not reflect the most recent accounting statements. Based on that, one can earn risk adjusted returns of the magnitude of up to 9 per cent per year "with rudimentary analysis of the most commonly reported accounting information." Abnormal profits thus earned are not because of omitted risk factors. They are strictly a result of fundamental analysis and taking advantage of market inefficiencies.

So there you have it. General statements about active portfolio managers' underperformance mask the true story; the devil is always in the details.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

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