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Knowledge@Wharton Article Looks at Index versus Actively Managed Funds

A February 3, 2011 post at the Knowledge@Wharton blog takes a look at why, given the superior track record of passively managed index funds over actively managed funds, consumers still prefer active management.  

Index funds, which try to simply match the performance of a broad market sector, have consistently beaten "actively managed" funds, where professional money managers attempt to outperform the market by picking the hottest stocks and bonds.

. . . 

But if this is so, why do a majority of investors still choose active management? Indexing, or "passive management," accounts for only about 13% of assets in mutual funds holding stocks. It doesn't seem to make sense.

To try to answer this question, the article looks to Wharton finance professor Robert F. Stambaugh who, with Lubos Pastor, a finance professor at the University of Chicago Booth School of Business, has issued a paper titled, "On the Size of the Active Management Industry," documenting research demonstrating "that investors use active management in a kind of arms race to unearth a limited number of bargain-priced investments."   Stambaugh and Pastor argue that a key factor:

. . . is investors' rational belief that active managers have a better chance of sniffing out good deals if there are not too many managers looking. A rational investor will pull money out of actively managed funds if the results are disappointing, but he will not pull out entirely because he realizes that other investors will withdraw money, too. That will leave less money to chase the few bargains, making them easier to find. "We wanted to come up with a rational explanation for why, despite this rather mediocre track record for active management, the lion's share of money is still managed that way, as opposed to passively," Stambaugh says. "We think we have done that."

The article, and Stambaugh and Pastor, admit that there may be other factors at work behind investors' preferring actively managed fund products, "namely industry marketing, pressure from brokers and financial advisors, ignorance and so forth."  But the Stambauh and Pastor research provides a simpler explanation for investor behavior: "There's no reason to resort to calling investors stupid if you can explain [their behavior] without doing that."

The full text of the Knowledge@Wharton post is available at:

The full text of Stambaugh and Pastor's paper is available at: