Conventional wisdom suggests that hiring an active equity manager is a fool's errand. I once believed this too, as did many of my academic contemporaries enamored with an elegant yet flawed notion of efficient markets.

Many advisors have since jumped on the bandwagon, believing that hiring an active manager represents the triumph of hope over reality. The passive parade has only grown more popular in recent years, proudly marching through the last decade with no excess returns to show for it.


Yet the academic evidence in favor of active management demonstrates otherwise. When active managers are separated from their index cousins, a different picture emerges. By studying this question, I've found it possible, as have some of my academic peers, to identify active managers capable of generating excess returns.

This puts us at odds with many outspoken members of the financial planning community. But the drumbeat of peer-reviewed evidence only grows louder as we turn from our collective infatuation with indexing.

When I received my PhD in the late 1970s, the popularity of the Efficient Markets Hypothesis and Modern Portfolio Theory were approaching their zenith. As an early believer, I even demonstrated these concepts to my students with a dartboard.

Yet before long, the Capital Asset Pricing Model began failing empirical tests. The Efficient Markets Hypothesis now resembles Swiss cheese, rather than a foundational concept.

When they do their job skillfully, active equity managers exploit market inefficiencies others choose to ignore. It only makes intuitive sense that, with the vast resources available, superior stock- picking skill is regularly demonstrated by active equity mutual fund managers.

I've found this to be especially true when these same managers are unconstrained by style box mandates and take high-conviction positions. Rather than being rare, excess returns are plentiful.

With this in mind, the active versus passive debate has grown stale. The question we should ask is: Do we have the courage to act on the ample evidence?

This is the essence of Behavioral Finance - that markets make pricing errors consistently. Do we choose to follow the noisy marching band, no matter how bad the tune, or listen to the evidence and pocket excess returns for our clients?

C. Thomas Howard, Ph.D., is CEO and director of research at AthenaInvest and a professor at the Reiman School of Finance at the University of Denver.

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