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Three Reasons Active Equity Managers Underperform

Three reasons explain active equity manager underperformance. First, as is now better understood, the returns to passive index component firms often are asymmetrically distributed with a mean larger than than the median, implying that random portfolio selection from index firms is likely to underperform the index. Second, while there typically are a large number of index stocks that outperform the index total return, active equity managers disadvantage themselves with "style biases" that limit the stocks they are willing to buy, a bias the index rejects. Third, passive equity indexes like the S&P500 do not trim winners or rebalance away from winners toward losers while active managers do so routinely. While asymmetric return distributions can explain why indexing is hard for random stock picking to beat, style biases that limit the set of stocks active equity managers pick from and an unwillingness to let winners ride may be as important in explaining the remarkable inability of active equity managers to keep up with passive index funds.