A Plan for Active to Beat Passive

We’ve all seen the reports showing active manager underperformance (I will cite the Morningstar report in this article: https://www.morningstar.com/funds/active-funds-fell-short-passive-peers-2023). The results are dismal for active managers:

Drilling in on just the equity managers over the past 10 to 20 years, approximately 80% underperform!  

Here is the plan to get active managers to beat passive. Below is a histogram of how much Active Large-Blend Funds have underperformed over the past 10 years. One complication is that 35% have merged or been liquidated.

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We took the data, excluded the merged and liquidated, and then fit it to 100%.

We’ve taken the data and consolidated it into three buckets. First, the 13% that beat passive (this aligns with the 12.7% cited in the first table). Second, the 14% that were worse than 4% behind passive. Third, the 72% majority of managers between -4% and 0% behind passive.

Why 4%? 4% is the average difference we’ve measured between our clients’ position sizing and the rules-based position sizing they create in Alpha Theory (highlighted difference in green below).

If active managers followed a rules-based approach to position sizing and picked up 4% of return, then 85% of active managers would beat passive. Now, of course, results may vary, so let’s assume we picked up 2%. That would still put 57.8% above passive!

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The path to active outperformance starts with a disciplined, rules-based approach to position sizing.

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At Alpha Theory, we’ve worked with 300+ managers over almost 20 years who have forecast over 1 million price targets. Their price targets are 3x better at predicting future returns than their position sizes. And if you add a manager’s conviction level and rules, it is 5x better. There is predictive skill in a manager’s fundamental research.

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The issue is how their research becomes a portfolio. This is where Alpha Theory fits in (you can also do a basic version in Excel). Collect research in a central place, synthesize it, define position sizing rules, and then create alerts to highlight deviations from the process. This is the plan. With a disciplined, rules-based approach to position sizing, active managers can achieve the true potential of their research and shift the balance toward active investing.

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