Sharpening the Arithmetic of Active Management
23 Pages Posted: 7 Oct 2016 Last revised: 23 Feb 2018
Date Written: 2018
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: Suggested Citation