Why Might Investors Choose Active Management?

Abstract

We investigate why investors may be willing to participate in active management, notwithstanding that the average manager is likely to generate negative alpha after fees. We model the alpha an investor expects from a dynamic strategy of investing in a portfolio of active investment managers, and the fee they are willing to pay for this strategy. The investor considers their ability to select good managers, and anticipates replacing managers when alpha expectations fall either due to a loss of confidence in the manager�s ability or from the dilutive impact of new fund flows. A numerical calibration, using inputs consistent with the literature, finds some investors can credibly select active managers at observed fee levels. Computations suggest that investors who are overly optimistic about their ability to select active managers or overlook the dynamic elements of investing with active managers may incur significant losses.