The Economist Asia - February 10, 2018

The EconomistFebruary 10th 2018 Finance and economics 65

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S THERE hope for fund managers after

all? Conventional “active” managers,

who try to pick stocks that will beat the

market, have been losing ground to “pas-

sive” funds, which simplyown all assets

in a given sector in proportion to their

market value. The main advantage of the

latter group is that they charge a lot less.

William Sharpe, a Nobel prize-

winning economist, argued in 1991 that

the “arithmetic of active management”

means that the average fund manager is

doomed to underperform. To understand

why, assume that there are equal num-

bers of active and passive managers and,

between them, they own all the market.

The market returns 10%. How much will

the passive managersearn? The answer

must be 10%, before costs. The active man-

agers own that bit of the market the pas-

sive managers don’t. But that proportion

of the marketmust, thanks to simple

arithmetic, also return 10%, before costs.

Since the costs of active investors are

higher, the average active manager must

underperform. These numbers hold true,

regardless of the proportion of the market

owned by the two groups.

But Lasse Heje Pedersen, in a new pa-

per* in the Financial Analysts Journal,

takes issue with Mr Sharpe’s argument.

Mr Pedersen, who is an academic and a

principal atAQR, a fund-management

firm, says that Mr Sharpe’s reasoning only

holdstrue if the composition of the mar-

ket remains unchanged.

In practice, new companies float on

the market; others are relegated from—or

promoted to—indices such as the S&P500;

and some firms buy back their own

shares. The holdings of those investors

that were truly passive (ie, did nothing at

all) would cease to resemble the market.

Someone who boughtall listed American

stocks in 1986 and did nothing would by

now own less than half the market.

So passive investors have to trade to

keep their portfolios in line with the index.

That gives active managers the chance to

outperform. Shares in new issues tend to

rise when they float. If passive investors do

not take part in the flotations (because the

stocks are not yet in the index), they will

miss out on those gains. But suppose they

do take part. A popular new issue will be

oversubscribed and passive investorswill

get fewer shares than they desire. They will

have to top up their holdings after the flota-

tion when the issue has risen in price. Con-

versely, passive investors will get their full

allocation of shares in unpopular flota-

tions, which will probably fall in price.

These points are valid. But how signifi-

cant are they? The average annual change

in the composition of securities in the S&P

500 index is around 7.6%. On thatbasis, the

annual trading costs for a passive investor

might be about a quarter of a percentage

point. Even including the index manager’s

fee, the total cost is still well below the

charges made by most active managers.

When it comes to bond indices, how-

ever, the market changes a lot more fre-

quently. That is because, whereas equities

are permanent capital, bonds have shor-

ter maturities (and some issuers default).

For an investment-grade index, the turn-

over is 49% a year and for high-yield, or

“junk”, securities, it is 93%. So trading

costswill be markedly higher.

Another flaw in tracking corporate-

bond indices, weighted by market value,

is that investors end up with the biggest

exposure to the most indebted compa-

nies. All thissuggests that fund managers

might have more scope to beat bench-

marks in bond markets than they do in

equity markets. Another paper by Mr Pe-

dersen’s colleagues atAQR(“The illusion

of active fixed-income diversification”)

shows that fixed-income managers did in-

deed outperform their benchmarks, after

fees, over the 20 years from 1997 to 2017.

But there is a catch. AQRfinds that the

reason active managers outperformed

the indices is that their holdings were

highly correlated with junk-bond returns.

These performed very well over the per-

iod as a whole. But they exposed the man-

agers to more risk. Their decision might

not have turned out so well.

Indeed, if investors were buying bond

funds in order to diversify from equities,

then the managers were actually under-

cutting their strategy. Economic scenarios

that are bad for equities (recessions, rising

interest rates, falling profits) tend to be

bad for junk bonds as well.

It is one thing to discover a theoretical

way for active managers to outperform. It

is another to identify individual manag-

ers who can reliably do so.

Buttonwood Breaking the bonds

Passive funds tracking an index lose out when its composition changes

..............................................................

*“Sharpening the arithmetic of active management”,

by Lasse Heje Pedersen, Financial Analysts Journal,

January 2018.

Economist.com/blogs/buttonwood

the suspicions prove true, a further rush

out of crypto-currencies might follow.

Recent weeks have seen other bad

news. In Japan authorities raided the of-

fices of Coincheck, a virtual-currency ex-

change, after $530m was stolen in the larg-

est ever crypto-theft. In America regulators

shut down an “initial coin offering” (which

raises funds by selling digital “tokens”) by

AriseBank, alleging an investor scam. And

BitConnect, a platform thatborrowed cus-

tomers’ crypto-currency in exchange for

monthly returns, folded in mid-January

following allegations that it was running a

Ponzi scheme. At its peak the company was

valued at around $2.5bn.

Regulators continue to weigh in. Bitcoin

“has become a combination of a bubble, a

Ponzi scheme and an environmental disas-

ter”, Agustín Carstens, the head of the

Bank for International Settlements,

warned this week, calling for more over-

sight. National authorities are obliging.

Chinese regulators have banned crypto-

currency trading on both domestic and for-

eign platforms, and the Indian finance

minister has promised to crack down on

their use for illicit activities. In America the

heads of the Commodities Futures Trading

Commission and the Securities and Ex-

change Commission, two regulators, testi-

fied to a Senate Committee this week; they

agreed on the need to protect investors, al-

beit without stifling innovation.

Banks, too, are alert to trouble—from

potential losses, particularly on unsecured

lending, or from falling foul of anti-money-

laundering rules. Several, including Citi-

group and JPMorgan Chase in America,

and Lloyds in Britain, took the unusual step

of banningcustomers from buying crypto-

currencies with their credit cards.

Diehard believers—dubbed “crypto-

crazies” by Mr Roubini, who is the oppo-

site—see such restrictions as a typical back-