Geoff Warren: Active or Passive Depends on Your Situation

June 8, 2023

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The IAA’s Active Managers Council is launching a new video series, featuring experts on active management reviewing some of the benefits and misconceptions about active investing.

Our first video in the series features three questions with Geoff Warren, associate professor at Australian National University (ANU) and former research director at Russell Investments. He’s also worked as a fund manager and asset consultant. Currently, Warren oversees the ANU student managed fund.

In the video, Warren takes on Sharpe’s famous proposition, reviews some of the flaws in active management research, and shines light on why going active or passive is not an “either/or” choice.

“Whether you should be active or passive depends on your situation and what type of investor you are and what you’re looking for,” says Warren.

The Holes in Sharpe’s “Zero Sum Game”

The video leads off with Warren reviewing the limitations of William Sharpe’s famous “arithmetic of active management,” which characterizes investing as a “zero sum game” that active managers are fated to lose because of their higher fees. While Sharpe’s theory is “seductive,” says Warren, it’s not the best model for describing the markets.

Warren argues that the model developed by Sanford Grossman and Joseph Stiglitz is much more realistic. In the Grossman-Stiglitz equilibrium, active investors earn higher returns than passive investors, but those higher returns only offset the costs of earning those higher returns (such as research and trading costs).

“The evidence actually lines up a lot better with Grossman and Stiglitz than it does with Sharpe,” notes Warren. He cites a research paper from Jonathan Berk of Stanford University and Jules van Binsbergen of The Wharton School of the University of Pennsylvania, which supports the Grossman-Stiglitz equilibrium. That paper found that there is usually gross alpha in active management, though net alpha is usually around zero after accounting for fees.

Warren argues that Berk and van Binsbergen’s work shows that “active management actually works,” adding “if you can pick good managers, if you can find a skilled manager before everybody else realizes, you can probably do quite well at it.”

Warren also notes that Sharpe’s theory contains some “very strong assumptions” that do not take market dynamics into account. For example, Sharpe fails to consider that:

• “There is no pure market universe.” Investors do not all operate in the same market universe. Different investors operate in different spheres.
• Index funds need to trade. Indexes are not static and change over time, and when that trading occurs it can create wiggle room for active management.
• Sharpe doesn’t rule out active managers winning at the expense of others. This is where relative skill and the Grossman-Stiglitz equilibrium may come into play.
• Sharpe only considers gross returns and fails to account for other metrics that investors care about, including risk and tax.

Active and Passive in Portfolios

Warren concludes by talking about how investors can make the best use of active and passive in their own portfolios. Warren lists five scenarios where an investor might prefer active management:

1. In markets where there is no passive alternative available, such as the markets for most alternative investments;
2. In markets where the available indexes don’t match the investor’s objectives;
3. When the index is not the best way to hold the market;
4. When the environment favors active managers, for instance, when there is high cross-sectional volatility or the market is inefficient; and
5. When the investor has skill, either in identifying good investments or good active managers.

No Blanket Rule

“For some people, active will be right; for some people, passive will be right,” concludes Warren. “There’s many reasons why you would choose active over passive, and I don’t think there should be a blanket rule.”

He adds that pitting active and passive investing as “two warring tribes” does a disservice to investors and is “entirely the wrong way to look at it.”