The Big Picture | Active Management and Market Efficiency
March 20, 2019
It’s easy to take market efficiency for granted. Investors in the U.S. public markets are fortunate. They can generally assume that prices of securities will reflect the business conditions faced by issuers, that those prices will adjust quickly to changes in those conditions, and that the relationship between risk and reward will be consistent across assets – all hallmarks of an efficient market.
But market efficiency is far from a given. Active investors in the markets are instrumental in making markets work well. And achieving and maintaining market efficiency requires a commitment from policymakers to support regulations and market structure that create a foundation for investor confidence.
In a new paper, titled “Active Management and Market Efficiency,” Professor Russ Wermers of the University of Maryland’s Robert H. Smith School of Business focuses on a critical contributor to market efficiency: the activities of active investment managers. The work on this paper was supported by the Investment Adviser Association’s Active Manager Council.
Wermers concludes that “all investors, both active and passive—as well as the real economy—benefit from the efforts and cost expenditures of active managers.” Not only do active managers generate “value-added for investors,” he notes, they simultaneously make “public security markets more efficient.”
“All investors, both active and passive—as well as the real economy—benefit from the efforts and cost expenditures of active managers.”
Importantly, these efficiency effects are amplified for small- and mid-capitalization stocks which are, in aggregate, overweighted in actively-managed funds. This improved market efficiency in turn makes it easier for these companies to raise capital for investment in the real economy.
In the heart of the paper, Wermers describes the mechanisms that translate active managers’ activities into market efficiency. Specifically:
- Active managers correct market anomalies. The empirical evidence indicates that “active managers often exploit and correct market mispricings.” These mispricings – which are called “anomalies” when they occur regularly – can be the result of investors’ behavioral biases.
- Active managers provide liquidity. Because they have the ability to make discretionary trades, “active managers clearly can play a role in providing intraday liquidity to other traders.” By contrast, index funds must trade when experience investor flows, and their selection of securities to trade is limited by the need to mirror the index. “Active funds can take actions to reduce the impact of investor flows,” notes Wermers, “Actively maximizing the insurance value of pooled liquidity.”
- Active managers incorporate information into market prices. Passive investors have little incentive to spend resources on news-gathering and information analysis, except as related to proxy voting. Therefore, argues Wermers, “This leaves active investors as the conduit for the incorporation of costly news into prices.”
In the process, active managers “generate a large positive externality that benefits all investors in the financial markets, both passive and active,” notes Wermers. This “societal value-added” is in addition to the benefits that active managers provide to their investors, in the form of ability to exploit mispricings and to tailor risk-return profiles to individual preferences.
In sum, concludes Wermers, “the average ‘alpha’ provided by active managers (meaning the excess return above the relevant benchmark index), even gross of management fees, does not adequately capture the value of the active management industry to capital markets.” The total value-added that active managers generate for society as a whole is significantly higher than the value of the benefits that they provide to their own investors.
“Active managers generate a large positive externality that benefits all investors in the financial markets, both passive and active.”
In other sections of the paper, Wermers reviews the academic theory on efficient markets and the role of active management, recent trends in assets managed by active and passive investors, and potential future trends in the active management industry.
“Active Investing and the Efficiency of Security Markets” is an important reminder of the essential role that active management plays in ensuring the health of the financial markets and, therefore, the economic prosperity of all.
About the AMC
The IAA formed the Active Managers Council to support education and research on the value of active management for investors and the capital markets and to engage on relevant public policy issues. For more information, visit ActiveManagers.com.