Why Active Investors Matter in an ETF Era

SMITH BRAIN TRUST – With passively managed funds and ETFs surging in popularity in recent years, you might think that active investment managers would soon be a relic of the past, sidelined by broader finance trends. You’d be wrong, says Maryland Smith’s Russell Wermers.

In a new academic working paper, Wermers explains why active managers are more important than ever to the efficiency of security markets. Active investment managers counteract the biases of other investors, and help to smooth out market anomalies that are created by the “misbehavior,” or biases, of other market participants. Plus, he notes, active management assures liquidity in the market – stocks that tend to be owned by actively managed funds are more liquid than those that tend to be held more heavily by passively managed funds.

And it’s those active investment managers that take in the latest news affecting a company, industry or sector, and buy or sell on it, translating the development into price action that benefits “the entire marketplace,” says Wermers, professor of finance and director of the Center for Financial Policy at the University of Maryland’s Robert H. Smith School of Business. And, by fostering the efficiency of security markets, active managers help to improve the capital-raising abilities of small- and middle-sized U.S. firms, since their securities tend to trade less frequently and are more susceptible to being mispriced by the market.

"Active management is crucial for our economy, for the liquidity of securities in the market. And active managers do provide externalities – positive externalities or benefits, if you want to put it that way – for those who index,” Wermers says, discussing his working paper, Active Investing and the Efficiency of Security Markets, on the Money Life podcast with Chuck Jaffe.

"What used to be called Alpha is now becoming Beta, which means that things in the past that were sort of mysterious sources of Alpha – like momentum or like value stocks or using idiosyncratic volatility or things like that – are now well known to be reliable or semi-reliable sources of return. And so they can be quantified and they can become rules based."

What emerges, he says, is the middle ground of "quasi active" investing that is becoming cheaper, in addition to “truly active” fundamental stock picking or bond picking strategies, and it's been beneficial for everybody.

“Policymakers and regulators should think about the benefits of active management and not make active management so difficult to invest in, that individuals are pushed into index funds to the point that we don't gain the benefits of the active management for those index funds," he says.

Wermers’ research was supported by the Investment Adviser Association’s Active Managers Council, a trade group that represents SEC-registered investment management firms.