FundQuest Study: Active vs. Passive Investment Management

White paper identifies conditions under which active management has added value

FundQuest released a white paper on active versus passive investment management on Wednesday, June 30, that is intended to provide "actionable information" as a reference tool for portfolio construction. The firm said its study, "When Active Management Shines vs. Passive: Examining Real Alpha in 5 Full Market Cycles Over the Past 30 Years," may help financial advisors and investors create optimal mixes of active and passive strategies. The study also provides insight on the types of market environments in which active management has added value. And it identifies other factors that may affect real alpha generation.

FundQuest's research examined the historical performance over five market cycles starting in January 1980 of some 32,000 U.S. domiciled mutual funds representing more than $7 trillion of assets as of February 28, 2010. The research focused on four questions.

In what categories should investors utilize active management? Of the 73 categories in the study, FundQuest recommended a bias to active management in 23 categories and a bias to passive management in 22 categories, with 28 categories deemed to be neutral (no bias).

What percentage of assets should be allocated to active management? FundQuest found that some managers generate positive real alpha, even in categories where active managers have historically underperformed their benchmarks. The percentage of managers in each investment category that outperformed their category benchmarks varied significantly from category to category.

In what types of market environments has active management shined? Researchers found that on average, before adjusting for risk, active managers generated positive excess returns in bear markets and negative excess returns in bull markets. But the situation reversed after adjusting for risk, as active managers in general generated higher risk-adjusted returns than their passive benchmarks in bull markets and lower risk-adjusted returns than their benchmarks in bear markets.

What factors might have an impact on alpha generation? FundQuest identified several factors that had a statistically significant influence on alpha generation:

? Manager tenure: longer tenure (individual or team) generated higher alpha

? Net expense ratio: lower expenses generated higher alpha

? Volatility (defined as standard deviation): lower volatility generated higher alpha

? Previous market cycle downside-capture ratio: the lower the downside capture of the previous market cycle, the higher the alpha in the following market cycle

? Previous market cycle alpha: the higher the alpha of the previous market cycle, the higher the alpha in the following market cycle

"The discussion on the benefits of active and passive management continues, especially after 2008, a year in which active equity managers failed to generate positive excess returns," Jane Li, manager of investment and research at FundQuest, said in the announcement of the white paper. "While investors often use excess returns to measure if a manager has added value compared to a benchmark, we believe alpha is a more appropriate measurement of a manager's relative performance after adjusting for risk. Our analysis found that after adjusting for risk, active managers on average generated positive alpha in bull markets and negative alpha in bear markets over the thirty year period."

Michael S. Fischer ( is a New York-based financial writer and editor and a frequent contributor to

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