Why Might Investors Choose Active Management?

49 Pages Posted: 24 Feb 2011 Last revised: 20 Feb 2013

See all articles by Geoff Warren

Geoff Warren

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Statistics

F. Douglas Foster

The University of Sydney - Discipline of Finance; Financial Research Network (FIRN)

Date Written: February 22, 2011

Abstract

We investigate why investors may be willing to participate in active management, notwithstanding that the average manager is likely to generate negative alpha after fees. We model the alpha an investor expects from a dynamic strategy of investing in a portfolio of active investment managers, and the fee they are willing to pay for this strategy. The investor considers their ability to select good managers, and anticipates replacing managers when alpha expectations fall either due to a loss of confidence in the manager’s ability or from the dilutive impact of new fund flows. A numerical calibration, using inputs consistent with the literature, finds some investors can credibly select active managers at observed fee levels. Computations suggest that investors who are overly optimistic about their ability to select active managers or overlook the dynamic elements of investing with active managers may incur significant losses.

Keywords: Investment Management, Active versus Passive, Manager Selection

JEL Classification: G11, G23

Suggested Citation

Warren, Geoffrey J. and Foster, F. Douglas, Why Might Investors Choose Active Management? (February 22, 2011). Available at SSRN: https://ssrn.com/abstract=1767543 or http://dx.doi.org/10.2139/ssrn.1767543

Geoffrey J. Warren (Contact Author)

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Statistics ( email )

CBE Building 26C
Kingsley Sreet, Acton
Canberra, ACT 0200
Australia

F. Douglas Foster

The University of Sydney - Discipline of Finance ( email )

P.O. Box H58
Sydney, NSW 2006
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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