Active management refers to the investment style in which a portfolio manager builds a portfolio out of handpicked, specifically chosen securities.

Passive management refers to the investment style in which the manager seeks to mimic or track the performance of an index.

For decades, academic finance has been trying to teach us something important: If the “average” portfolio manager in an asset class charges higher fees than the index (and most do), the “average” manager will deliver net investment performance worse than the index. Why? By definition, the “average” return in an asset class is the performance generated by the blend of all the assets in that class before fees.

So, unless you’re confident you know how to pick above average managers, you’re better off with an index. The higher the management fees, the more this holds true.

What is an index? An index is the statistical aggregation of the securities in an asset class (or any other grouping). Once an index is created, it can be made investable by issuing securities designed to track it.

What is a benchmark? A benchmark is an index used for the purpose of measuring the relative performance of a portfolio.

Active management is only better when a manager can clearly demonstrate consistent outperformance, net of fees. Competitively viable passive products are sold on the basis of low total transaction costs and expenses. An expensive index fund wouldn’t make much sense as a product. Of course one must watch the fees and commissions charged by advisors, brokers, and traders getting paid to provide you exchange-traded funds (ETFs), no-load mutual funds, or index funds, however, it’s an easy bet that they still add up to less than most active managers charge for access to their skill.

We can easily assert that active management is only better than indexing when a manager can clearly beat the index, net of fees, but we still have the challenge of deciding which asset classes to be in, how to decide whether or not to invest actively or passively within them, whether or not a viable investable index exists, and how to find managers that are going to outperform their benchmarks. That’s a lot to consider for a short article like this one, but the two most important questions are fair game.

First, where should an investor go to look for good managers and, second, how can you tell when you have found one?

First: Where Skill Matters

If you want to be a good active manager, find an inefficient asset class and then work your tail off! Good active managers outperform their benchmarks over the long-term and every good active manager knows how hard this is to achieve. However, the more efficient an asset class is (see our Q2 2009 newsletter for an explanation of efficiency), the harder it is to consistently outperform over the long-term.

There are many sources of inefficiency which can create opportunities for active managers: Inefficient asset classes are found where it is hard to get access to the market or to the deals themselves, difficult to obtain information or prices, hard to negotiate or trade the assets successfully, or generally hard or expensive to develop the skill or technology necessary to participate.

It is also the case that many asset classes simply do not lend themselves well to passive investing. Imagine how one might try to construct an investable passive index for investing in venture capital, low-cost housing, Missouri farm land, or sculpture. This does not mean such things haven’t been tried, but the products have not done much in the marketplace.

Second: How Skill Matters

Good active management requires superior access, information, or skill and the ability to use it, consistently over time. Superior access can come from money, memberships, credentials, licenses, permits, patents, citizenships, or even willingness to be ostracized, break laws, or ignore social conventions.

Manager skill is an amorphous attribute, but it certainly applies to gifted thinkers, adroit negotiators, and accomplished risk managers. If you find a good active manager he will likely appear better, smarter, and harder working then a poor one.

Information “edge” is the stock-in-trade of the successful active manager: Edge is the combination of hard work and skillful application of the facts and figures. Information edge is so valuable, in fact, that some participants are willing to risk prison to obtain it.

Just remember one thing: Aggression and ambition are easily taken for intelligence. Don’t be fooled.

How Do You Keep Score?

If you want to watch an active manager look dyspeptic, ask for his or her “information ratio.” This ratio provides a numerical test for the value of their active management relative to their benchmark. The Sharpe ratio is the most famous of such ratios, but many variations of it exist. Fundamentally they all attempt to do the same thing: Evaluate the active manager’s relative performance based on the relative amount of risk taken to generate it. And since at least half the managers in an asset class will have negative information ratios, even before fees, it makes sense that this statistic sells a lot of Mylanta.

But things are never simple or easy. Depending on which measures are used and the frequency of those measurements, it can take five or even ten years of data points to produce statistically valid results from information ratio computations. And this assumes, of course, that it is possible to find, create and maintain a relevant benchmark.

So in practice, it’s fairly difficult to tell real portfolio “alpha,” demonstrable and consistent outperformance based on superior active management, from those taking credit for luck or market “beta,” the fruits of simple asset class participation.

Conclusion

Good active management is clearly of great value, but it really only makes sense for inefficient asset classes. Indexing is likely to achieve better net results in efficient asset classes. Managers that gain access to superior information and have the skills to apply it can generate tremendous returns for their investors.

Good portfolio managers realize that if an asset class is highly efficient, their customers should probably own the index. This is not a criticism of any manager, merely a reflection of a basic statistical reality: It is extremely difficult to outperform an efficient marketplace consistently over the long-run. And where the opportunity of outperformance is overly difficult or expensive, buy the index. You may even realize diversification and liquidity benefits.

There has been an accelerating trend in recent years to create passively managed investable indices of a wide group of asset classes and subclasses, index funds, ETFs, ETNs, index futures, index derivatives, and every other imaginable vehicle. Advocates claim that index funds routinely beat a large majority of actively managed mutual funds after deducting fees and expenses.

At Wanger Investment Management, we believe in the fundamental principles of portfolio construction:

• Use Diversification
• Manage liquidity
• Take advantage of low correlations
• Define superior performance as the best total return for a particular level of risk.

Good portfolio managers understand that in efficient asset classes it makes sense to own the benchmark. Active management can, and should, add meaningful value to investors participating in inefficient asset classes. But, unfortunately, active management is often sold to customers without benefit or justification.

The moral of the story: When better really is better, seek alpha and buy the good stuff! But beware of cheap knockoffs!

Eric Wanger, JD, CFA, President of Wanger Investment Management, Inc. and Portfolio Manager, Wanger Long Term Opportunity Fund