Sharpening the Arithmetic of Active Management

23 Pages Posted: 7 Oct 2016 Last revised: 9 Aug 2017

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Date Written: August 2017

Abstract

I challenge Sharpe’s (1991) famous equality that “before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar.” This equality is based on the implicit assumption that the market portfolio never changes, which does not hold in the real world because new shares are issued, others are repurchased, and indices are reconstituted so even “passive” investors must regularly trade. Therefore, active managers can be worth positive fees in aggregate, allowing them to play an important role in the economy: helping allocate resources efficiently. Passive investing also plays a useful economic role: creating low-cost access to markets.

Keywords: active management, passive investing, index funds, investment management, asset pricing, market efficiency

JEL Classification: G02, G10, G14, G20, G23, E44

Suggested Citation

Pedersen, Lasse Heje, Sharpening the Arithmetic of Active Management (August 2017). Financial Analysts Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2849071

Lasse Heje Pedersen (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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