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When Investment Skill Is a Bad Thing
If most asset managers were truly skilled investors, earning alpha — and the fees that come with it — would get a lot harder, a Wharton professor argues.
Investors surely wish all of their active managers were better at beating the market — but the asset management industry might be better off keeping some duds around.
In a newpaperfor the National Bureau of Economic Research, Wharton School professor Robert Stambaugh argues that more skill across the board would result in lower excess returns. More investors would be accurately identifying and trading mispriced securities, and thus diminishing the potential for alpha.
“A stock that is truly underpriced is more likely to be identified correctly as such by active managers, and that stock is more likely to be bought by them,” he wrote. “This collective higher demand for the stock raises the price managers pay for it, reducing the investment profit they make from buying it.”
Active managers earn fees partly based on their ability to outperform markets, including, in some cases, a hurdle rate they must beat to start accumulating performance fees. As a result, more investment skill industry-wide would result in lower profits, so long as fee structures remain unchanged.
“A more-skilled manger should receive more fee revenue than a less-skilled manager, but that is not the whole story,” Stambaugh wrote. “There are many active managers.” If most of those managers became more skilled, he added, it is “plausible” that fee revenue would decrease overall.
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Investors in actively managed funds would also be worse off in this scenario, as they would be paying fees for lower returns. According to Stambaugh, investors would “rationally allocate less to active funds and more to index funds,” further reducing the potential revenue for active managers by lowering their assets under management.
“If greater skill spells less revenue, an upward trend in skill represents a potential challenge for the active management industry,” he wrote. “Of course an industry of competing active managers cannot decide to calm that headwind by becoming less skilled. Applying more skill is in each manager’s individual interest.”
Greater investment skill would hurt the asset management industry’s profitability, Stambaugh argued, but the more efficient markets resulting from more skillful trading would be better for society at large.
“Greater skill produces stronger price correction in stocks,” he wrote. “Having prices more accurately reflect underlying fundamentals can allow more efficient resource allocations.”