Skill and Profit in Active Management
47 Pages Posted: 1 Jul 2019 Last revised: 12 Feb 2022
Date Written: June 2019
I analyze skill’s role in active management under general equilibrium with many assets and costly trading. More-skilled managers produce larger expected total investment profits, and their portfolio weights correlate more highly with assets’ future returns. Becoming more skilled, however, can reduce a manager’s expected profit if enough other managers also become more skilled. The greater skill allows those managers to identify profit opportunities more accurately, but active management in aggregate then corrects prices more, shrinking the profits those opportunities offer. The latter effect can dominate in a setting consistent with numerous empirical properties of active management and stock returns.
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