Research by Professor Lasse Heje Pedersen featured in the Economist

Professor Lasse Heje Pedersen’s article Sharpening the arithmetic of active management is making waves around the world, with mentions in Wall Street Journal, Bloomberg, Risk, and, most recently, The Economist. The article has implications for the future of asset management and takes issue with a famous argument by Nobel Prize winner William Sharpe, called “Sharpe’s arithmetic of active management”.

William Sharpe’s argument from 1991 is that the overall groups of active and passive investors must deliver the same performance before fees and, since active managers charge larger fees, active investors must necessarily underperform.

However, this new FRIC paper argues that the reasoning only works if the market is unchanged while in real world the investment universe changes as new firms are listed on an exchange, old firms are delisted, market indices are reconstituted, etc.  For these reasons, active managers can in principle outperform in aggregate, at least before fees. Therefore, investors can both benefit from active investing and passive investing. Further, active investors are important for the real economy as they are needed when new firms raise capital.

More information

For more information, see the online version of the news article about Lasse Heje Pedersen’s new paper here: Passive funds tracking an index lose out when its make-up changes.

Sharpening the Arithmetic of Active Management, Lasse Heje Pedersen (2018), Financial Analysts Journal, forthcoming. Is active management doomed in aggregate and, if so, is the financial system doomed? For the future of asset management, read the article.