This morning’s Wall Street Journal advised us that the performance of many large institutional investors has lagged that of the equity market since the beginning of the recovery five years ago. The Journal attributed this performance gap to institutions’ moves into alternative investment categories such as hedge funds and private equity. The explanation may be even simpler than that. Any large endowment or pension fund will be diversified across a number of asset classes, and by definition the whole portfolio must underperform its best-performing component.
The most striking part of the article was a short quotation from Yale Professor William Goetzmann: “Alternative asset classes are expensive, especially if you have to live with the average fund instead of stellar funds.” Of course, at the end of the day, the average fund is exactly what the average investor has to live with.
This is a direct consequence of what Sharpe called “The Arithmetic of Active Management.” All asset owners own all the assets there are to be owned. Therefore the weighted average return of all asset owners will be the weighted average return of all assets — in other words, the capitalization-weighted market return.
As a group, passive managers accept the market’s return, which means that as a (weighted) group, active managers must also accept the market’s return. But the cost of running an active strategy means that the average active manager will typically underperform an index appropriate to his investment style, as our SPIVA reports have long demonstrated. All the children in Lake Woebegon may be above average. The average active investor is not.