How 'Turnover' Might Change Everything We Think We Know About Active Management

A break from conventional wisdom.

Clifford Asness, managing principal and chief investment officer of AQR Capital Management LLC.

Photographer: Chris Goodney/Bloomberg *** Local Caption ***Cliff Asness

"Before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar," Bill Sharpe, a legendary figure in the world of modern finance, famously wrote back in 1991. "After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar," he added.

His mathematical rule has been considered incontrovertible by doomsayers of active management at a time when the amount of money held in passively-managed, or indexed accounts, is soaring. But Clifford Asness of AQR Capital Management LLC has spotted something that might give proponents of passive investment — including himself — some pause. 

Asness points to a paper by Lasse Pedersen, a Danish financial economist employed by AQR. In the paper, Pedersen argues that Sharpe ignores a key element of real-world investing that, once taken into account, completely undermines his argument.

That element is the fact that indexes are not static; in other words new securities are added to them and older ones are taken away. That 'turnover' is large enough for active managers to create "noticeable" extra returns relative to their passive competitors, according to Pedersen.

"Active management can be worth positive fees," he said, while passive investors "may trade at less favorable prices than their active managers" while trying to maintain their market-weighted portfolios.

This in turn allows the active management sector to allocate resources efficiently, Pedersen argues.

Pedersen 1
Source: AQR

While Asness isn't yet completely convinced of Pedersen's claims, he is intrigued.

"How many of us often just cite 'the average can’t beat the average' and move on assuming we’ve smashed whoever we were debating? I know I have done it many times," Asness wrote in a blog post. "Sharpe's insight is, in my opinion, likely still mostly true, perhaps entirely true. But Lasse has, at the very least, created some doubt for me in something I was pretty sure about."

Pedersen doesn't answer the question of whether the active management industry has grown too large to justify its existence, Asness noted, and most active managers wouldn't want to characterize their roles as simply managing turnover in indexes.

But still, he believes that it's good to "turn over accepted wisdom with turnover," as the headline of his post reads.

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