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So Active Management Wins In Informationally Inefficient Markets?

Larry Swedroe Mar 16, 2015



Active Management Wins In Informationally Inefficient Markets


Even before looking at some evidence, I find it pretty amazing that this myth about active management as the winning strategy in inefficient markets manages to persist after the 1991 publication of William Sharpe’s brilliant short paper, “The Arithmetic of Active Management.”

Using simple arithmetic, Sharpe demonstrated that active management, in aggregate, must be a loser’s game. In aggregate, active managers must underperform proper benchmarks. Sharpe’s mathematical proof shows that this holds true not only for the broad market, but also when the market is in a bull or bear phase. And it also must hold true for market sub-sectors, such as small stocks or emerging market stocks.

Sharpe concluded: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”


  • DFA Emerging Markets Fund (DFEMX) had a percentile rank of 31.
  • DFA Emerging Markets Small Fund (DEMSX) had a percentile rank of 6.
  • DFA Emerging Markets Value Fund (DFEVX) had a percentile rank of 12.
  • DFA International Small Fund (DFISX) had a percentile rank of 7.
  • DFA International Small Value Fund (DISVX) had a percentile rank of 1.

The average ranking for the five DFA funds in these supposedly informationally inefficient asset classes was just greater than 11. That means DFA funds outperformed an average 89 percent of actively managed funds in their respective categories. That doesn’t sound like active management is the winning strategy to me. Not when 88 percent of the surviving actively managed funds underperform a passive strategy. And what’s more, this score understates the reality because about 7 percent of all funds disappear each year, and the Morningstar rankings contain survivorship bias. If survivorship bias were accounted for, the rankings of the DFA funds would have been even better.


The Myth of Active Management in Inefficient Markets


Now, it’s true that those figures are all better than the 85 percent of large-cap U.S. funds that underperformed their benchmark over the same period. But it doesn’t change the fact that active management clearly was a loser’s game anywhere you looked.

It’s also important to keep in mind that all of the data we’ve used here is based on pre-tax returns. And the greatest cost of active management in taxable accounts typically is taxes. So, if taxes were considered, the results would look even worse for active managers.


The Bottom Line



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