Noisy Active Management

Abstract

Lower skill of the active management industry can imply greater fee revenue, value added, and investor performance. Such outcomes arise in a competitive equilibrium in which portfolio choices of active managers partially echo those of noise traders and also contain manager-specific noise. Both sources of noise reduce managers’ skill to identify mispriced securities and thereby produce alpha. However, lower skill also means a given amount of active management corrects prices less and thus competes away less alpha. The latter effect can outweigh managers’ poorer portfolio choices, so that investors rationally allocate more to active management when its skill is lower.

Keywords: Active Management, Noise Traders, Skill

JEL Classification: G23, G12, G11