Paper 11S17 Does Active Management Provide Investor Surplus

Does Active Management
Provide Investor Surplus?

The Journal of Portfolio Management 2011.38.1:131-139. Downloaded from www.iijournals.com by Hassan Saleem on 12/07/11.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
Brian J. Jacobsen
Brian J. Jacobsen
is the chief portfolio strategist at Wells Fargo Funds
Management, LLC, in
Menomonee Falls, WI.
brian.jacobsen@wellsfargo.com
Fall 2011
JPM-JACOBSEN.indd 131
rice and value are two different things

and should not be confused. The
price of something is what a buyer
pays for it, and the valueis how much
something is worth. If the price is less than the
value to a buyer, then they have garnered a
consumer surplus. Economic theory suggests that
a buyer will not pay more than something is
worth in a free and informed exchange. Thus,
there is no such thing as a negative consumer
surplus.
In this article, I analogize investing to
consuming, introducing the concept of investor
surplus to parallel the concept of consumer
surplus. Using an arbitrage pricing framework, which is a building block of binomial
pricing for options, I show how to theoretically measure an investors reservation price.1
This is the maximum price an investor would
be willing to pay before the entire surplus
isgone.
With some goods, buyers may experience remorse if they must commit to buying
the good before experiencing the true value
of the good. This situation only arises in the
presence of incomplete or imperfect information. This is a typical situation when a
consumer must make a decision under uncertainty, weighing the perceived benefits against
the perceived costs. Similarly, investors commit
funds to a manager before discovering how
the managed portfolio will perform. Most
evaluations of whether portfolio managers
add value is based on an ex post analysis, but

investors (just like consumers) make ex ante
determinations of value.
If markets were complete, and information f lowed and was processed perfectly,
then portfolio managers would only need to
help clients with tax management and economizing on transaction and processing costs.
These are two valuable functions of portfolio
managers and can be approximated by the fees
charged by passive investment strategies, for
example, exchange-traded funds and index
funds. Investors actions, however, suggest
that they do not believe markets are perfect
enough to merit investing only in a passive
index and a risk-free security. Either there is
massive delusion on the part of investors, or
there is something to the idea that investment
management creates something of value,
even if that something is not in theform
of excess returns. For example, some people
could assign value to the prestige associated
with investing with a high-profile manager.
In this article, instead of trying to measure the value of qualitative dimensions of
investing with a portfolio manager (e.g., the
prestige factor), I focus on how managers can
add value by delivering alpha or by having
a beta in up markets that differs from that
managers beta in down markets (i.e., asymmetric risk exposure). What I show is that
this asymmetric beta exposure can create
investor surplus, along with alpha and other
The Journal of Portfolio M anagement 131
10/11/11 6:01:50 PM
sources of investor value. I also provide an approximation for measuring this value.
An Index versus a Benchmark
Passive portfolios are typically attempts at replicating the performance of a benchmark. Active management is an attempt at outperforming a benchmark by
adjusting the weights of the securities that compose the
benchmark in accord with the managers forecast of the
relative desirability of the securities.
An index and a benchmark are not the same thing.
An index is an indicator of how a particular subset of
the market is performing. A benchmark for a portfolio
manager may be an index, but is not necessarily an
index. A benchmark should take into consideration the
various constraints imposed on a manager and ref lect the
opportunity set from which the manager may select
investments. A benchmark may be a blend of indices
where the blend may change over time.
An index may not be an appropriate benchmark,
especially for an active manager. Active managers not
only adjust portfolio exposure to broad asset classes, such
as sectors, but also by substituting securities from outside
the index.
Index construction methodologies vary, but there are
some general characteristics of all indices that leave room
for portfolio managers to outperform the index itself. These
rules of weighting provide plenty of opportunities for an
active manager to add value to an otherwise passive portfolio by trading intraday or by taking preemptive action
between index reconstitution dates. Of course, this also creates a lot of room for an active manager to destroy value!
A further problem with purely passive investing is

that it can lead to investor indifference toward corporate governance issues. This is not only a problem with
passive portfolios, but it is also a problem with diversified
portfolios, because diversifying away all idiosyncratic
(i.e., security-specific) portfolio risk means that the individual risk of a security is irrelevant to the individual
investor.2 Thus, an individual investor will not care
about monitoring the individual securities within his
portfolio. Diversification can lead to investor indifference, which can then lead to a permissive environment
for corporate mismanagement known as the Peltzman
Effect (Peltzman [1976]).3 This may create a valuable
space in which activist investors can act.
In this article, instead of getting into the social
value of active investing, I focus on the value that comes
from a stylized model of active investing, which is giving
asymmetric exposure to the markets.
In the capital asset pricing model, a portfolio
has systematic risk, as measured by beta, and idiosyncratic risk, as measured by alpha. Asymmetric exposure
refers to an alpha or beta in one state of the worldfor
example, an up marketthat differs from the alpha or
beta in another state of the worldfor example, a down
market. For ease of exposition, in this article I focus
on beta exposure. An investor may not care whether
the asymmetric exposure arises from differing alphas
or betas, but some investors may care. For example,
investors may want to manage beta exposure on their
own. In that case, the investor may want a portfolio
manager to have consistent beta but a differential alpha.
By differential alpha, I mean an alpha in the up-state of
the world that differs from the alpha in the down-state
of the world.
Problems with Passive Investing
Passive investing can make sense if the individual

investor does not believe he has an informational or
institutional advantagefor example, lower brokerage
costsover a portfolio manager. One thing that is sometimes forgotten is that passive investing for everyone leads
to a logical contradiction, as pointed out by Grossman
and Stiglitz [1980]markets cannot deliver information efficiently if no one has an incentive to gather,
process, and act on information. In a way, there must
be an optimal level of ignorance in a market to give
investors an incentive to go through the costly process of
gathering, processing, and acting on information.
The Value of Active Portfolio

Management
Shukla [2004] compared the returns on mutual

funds with what would have been earned if there was
no active management of the fund. The findings do not
bode well for active managers; on average, investors lose
0.13% per month due to active management. Shukla
and Trzcinka [1992] provided a summary of performance evaluation and found only a few exceptions to the
general result that active management is ultimately costly
to investors (the exceptions are discussed by Keim [1989]
and Chen, Narasimhan, and Wermers [2000]). The cause
132 Does Active M anagement Provide Investor Surplus? Fall 2011
10/11/11 6:01:50 PM
of the loss to investors could be a form of compensation

for the variety of services that active managers, especially
mutual funds, offer: consolidated billing, recordkeeping,
the ability to buy fractional shares, accessing markets,
and so on. There could also be a prestige effect in investing
with a particular manager. This simply refers to the
ability of an investor to say, I invest with. But, in
general, is investor welfare enhanced through portfolio
management, especially active portfolio management?
In fairness to active managers, they often do face
many institutional constraints that may limit their effectiveness (Clarke, de Silva, and Thorley [2002]). They
may face constraints on the size of positions in any given
security, on their ability to short sell, or on their liberty
to deviate from a particular investment objective. All
of these limitsand morereduce their effectiveness
in generating returns superior to a passive portfolio. It
can also be argued that these constraints help prevent
an active manager from destroying any more value than
he otherwise would if left unconstrained. That is why
monitoring and enforcing these constraints are important parts of investment risk management.
Portfolio managers, in general, can benefit investors through the managers roles as intermediaries. Collective funds, unit investment trusts, and other pooled
investment vehicles allow for fractional share ownership,
lower transaction costs, access to markets that investors otherwise would not be able to have, conveniences
such as bookkeeping, and other valuable services. As
Ishow later in the article, better execution and cheaper
transaction costs are sufficient reasons to allow for intermediated investing, however, active management can be
valuable too, especially in an ex ante, subjective sense.
Framework for Measuring Investor
Surplus
The use of risk-neutral valuation is ordinarily

applied in the context of derivative security pricing, also
known as option pricing. I do the same thing by treating
a manager as an option. Ferguson and Leistikow [2001]
used a risk-neutral valuation model to determine appropriate discount rates in order to value a portfolio to its
different stakeholders: owners (i.e., investors in the portfolio), managers (i.e., portfolio managers or sub-advisors
of the portfolio), and service providers (i.e., advisors to
the portfolio). They treat a mutual fund as a stochastic
(or random) asset and find that active management
Fall 2011
enriches the service providers and the managers, but

not necessarily the owners. I show next how active management also creates value for the owners, or investors,
in the portfolio. I do this by introducing the concept of
investor surplus, which is analogous to the economic
concept of consumer surplus, when a consumer values
an item more than the item costs. The key is to look at
investing prospectivelyinstead of retrospectively. This
means shifting the focus from a realized perspective
to one based on investor expectations.
The first step in valuing an active managers performance is to identify the appropriate benchmark for
his portfolio. The correct benchmark should ref lect
all the possible combinations of securities available to
the portfolio manager. This is something that can only
be derived from the prospectus or investment policy
of the manager. Rarely will a commercially provided
index be the correct benchmark for a portfolio manager.
For example, an index represents a predefined portfolio
without allowing for variations in security weights that
correspond to the constraints placed on the manager.
Assuming the correct benchmark has been
selected, arbitrage pricing can be used to provide a first
approximation to the value an active manager brings
to managing a portfolio. The stylized model of active
management that I use in this article is one in which
the manager provides asymmetric exposure to a benchmark portfolio. In this model, a manager is treated as an
option on a portfolio composed of securities (that is,
the benchmark), with returns that are denoted by rS (the
return on the benchmark), and a risk-free bond, with a
return denoted by r f..
Assuming these securities (the benchmark and the
risk-free bond) have arbitrage-free prices, the synthetic
probabilities from an arbitrage-free portfolio can be used
to calculate the value of the asymmetric exposure. This
simply means that if we assume that the benchmark and
the risk-free securities are fairly priced, and that there
are only two possible states of the world, where the
benchmark is up or down, then we can derive synthetic probabilities for those two states of the world.
Using these synthetic probabilitieswhich are called
synthetic because they do not necessarily ref lect actual
probabilities, but only those that make the securities
fairly pricedwe can derive how valuable a portfolio
manager is in that type of environment.
A portfolios asymmetric exposure can come from
holding the benchmark and options, from a dynamic
10/11/11 6:01:50 PM
trading strategy, or from the use of active managers. For

simplicity, I will refer to a manager, but the framework
is general enough to handle all asymmetric exposures,
no matter how they are obtained.
For illustrative purposes, assume there are two possible states of the world: an up-state (denoted by u) and
a down-state (denoted by d). Each state can represent a
continuum of cases, covering every possible up or down
return. Similar to the capital asset pricing model, a manager has a gross return (before fees) in the up-state given
by rMU = U + r f + U (rSU r f ) and a return in the downstate given by rMD = D + r f + D (rSD r f ).
Think of these returns as coming from a managers alpha and beta when her benchmark is positive
or negative, respectively. If the alphas and betas in the
up- and down-states are the same, then this is symmetric
exposure to the benchmark. It is when the alphas and
betas are not equal that we get asymmetric exposure to
the benchmark.
In reality, alphas and betas may not be known with
certainty, but for illustrative purposes I will take these as
givens. These can be thought of as ex ante alphas and betas
giving the anticipated value of the portfolio. In this way,
investing is like an experience good, where a consumer
may not know ahead of time the actual quality of the
product (for example, buying a bushel of apples when each
apple cannot be examined before purchase of the bushel).
It is only after making the purchase that we can subsequently determine (or experience) the true quality of the
goodhowever, we commit our money ahead of time.
Through repeated interactions and the threat of retaliation
(for example, tarnished reputation, lawsuits, or not transacting in the future), there should be at least some limited
discipline imposed on merchants and portfolio managers
to make expectations consistent with reality.
Within the binomial (i.e., two-state) arbitrage
pricing framework, the synthetic probabilities can be
derived. There is an up-state of the world and a downstate of the world. To make this mathematically tractable,
in Equation (1a), the columns in the payoff matrix represent the two different states of the world of up or down
for the benchmark portfolio. Considering that the alphas
and betas of the manager are not certain, we can add a
risk premium to ref lect that uncertainty (rp ):
1 + rSD U
1 1 + rSU
= 1 + r + r 1 + r + r
1
f
p
f
p
D
(1a)
Equation (1a) simply says that $1 invested in the

benchmark will grow to $(1+ rSU ) in the up-state of the
world, but only $(1+ rSD ) in the down-state of the world.
The risk-free security will grow to $ (1+rf+rp ) regardless of the state of the world (up or down). The risk premium (rp ) is introduced to ref lect the uncertainty of the
managers ability to deliver asymmetric exposure to the
benchmark. The more uncertainty there is in the portfolio managers ability to deliver alpha or beta, the higher
the risk premium should be. The risk premium ref lects
the extent to which the investor believes the manager will
actually deliver the alphas and betas that are expected.
The risk premium should decrease as the manager behaves
more consistently. This implies that a consistent managers
maximum fee can be larger than that of an inconsistent
manager who has a higher risk premium.
The risk premium need not be the same in the up-state
and down-state, as assumed in Equation (1a). In this article,
it is taken as being the same, purely for simplicity. Each
casethe up-state and the down-stateactually reflects a
continuum of cases, where the first column corresponds to
any nonnegative value of the benchmark, and the second
column corresponds to the negative values.
If we assume the benchmark and the risk-free security are fairly priced, the unknown in Equation (1a) is
the column vector of synthetic probabilities, UD . From

matrix algebra, this is given by the following:
(r f + rp rSD )
U
1
=
(1b)
U

U
D
D (1 + r f + rp )(rS rS ) (rS r f rp )
Now, I want to evaluate the maximum amount

that an investor would be willing to pay for a portfolio
managers alpha or beta. If there is an expense set as a percentage of assets under management, the managers net
returns (after expenses and fees, e) are given as follows:

1 = (1 e ) (1 + rMU )(1 + rMD ) U
D
(1c)
The managers maximum-value expense (akin to

the investors reservation price), assuming the alphas and
betas in the up-state and down-state are known, is given
a priori by the returns consistent with the risk-neutral
probabilities,
e = 1
(1 + r f + rp )(rSU rSD )
(1 + rMU )(r f + rp rSD ) + (1 + rMD )(rSU r f rp )
(1d)
10/11/11 6:01:53 PM
The investor surplus can be thought of as the

difference between the maximum-value fee and the
actual fee charged. The investor is always willing to
pay less than e.
If a manager brings no asymmetric exposure (that
is, the up and down alphas and betas are the same), then
the maximum value is given by the following:
e=

1 + r f + rp +
(1e)
If a managers up-beta and down-beta are identical,

the only way a manager can earn a fee in this framework is through delivering positive alpha. An investor
who pays less than e is receiving investor surplus. The
more certain the investor is that the portfolio manager
can deliver that alpha, the more the investor would be
willing to pay.
If a manager offers asymmetric exposure to the
markets (where the alpha or beta depends on the state
of the world), then there is more scope for a manager
to earn his keep. For example, lets assume that the
manager is not expected to deliver any alpha. Despite the
lack of alpha, there is still the opportunity for a manager
to be valuable through asymmetric beta exposure. The
maximum value in this case is the following:
e=
states. The uncertainty around those anticipations can

be captured in the risk premium.
Because investors do not always express their
expectations through surveys, it is necessary to posit
a model of investor expectation formation. To model
whether active managers can create investor surplus,
take, for example, the S&P 100 Index. Assume a manager is benchmarked against this large-cap index and the
investors expectations of the markets ups and downs
can be captured by a two-state regression model where
the dependent variable is the monthly total return on
the index (TR), and the independent variables are the
trailing months return (TMR), the earnings yield (EY)
on the index, and the one-month Treasury constantmaturity yield (TY). This is just one simple model
of expectation formation. There are many more that
canand shouldbe used. This is one additional area
for research.
For the two-state regression, I used data from July
2001 to September 2010. I separated the data on the basis
of whether the months total return on the S&P 100 was
positive or negative. There were 64 months of positive
returns and 46 months of negative returns. The two
separate regression models were estimated as follows,
with t-values in parentheses:
(rSU r f rp ) U (r f + rp rSD ) + D (rSD r f rp )
(1 + r f + rp )(rSU rSD ) + (rSU r f rp ) U (r f + rp rSD ) + D (rSD r f rp )
Again, the investor will be willing (and happy)

to pay less than this. The difference between what the
investor is willing to pay and the amount the investor
actually pays is the investor surplus. If the manager
charges the maximum fee, then the investors surplus
is zero. In that case, competitive forces may force the
manager to charge a lower fee.
An Example
The preceding model assumes that the investor has

a view about what the up-state and the down-state of
the market will be. The investor also has an expectation
about the managers alphas and betas in those respective
Fall 2011
(1f )
Up-State: TR = 1.017 0.069 TMR + 0.537 EY

( 0.644 )
( 1.021)
( 2.000 )
0.448 TY
( 2.626 )
Down-State:: TR = 4.600+ 0.140 TMR 0.067 EY

( 2.064 )
( 1.183 )
+ 0.553 TY
( 1.540 )
( 0.184 )

(1g)
The coefficient of determination for each model

is 15.9% and 10.7%, respectively.
The preceding equations give the models for the
expectations (average) of market returns for any given
month. Clearly, the models are inadequate for actually modeling any given investors expectations, as
10/11/11 6:01:54 PM
Exhibit 1
Modeled Expectations of Up and Down Returns
Note: The exhibit charts the average upside return and downside return for any given month. Actual anticipations would be distributions around these lines.
the t-values are not statistically different from zero at

alow level of significance. This is purely for illustrative
purposes, however, and is not an attempt to model actual
investor expectation formation.
If a manager has an expected beta of one in both
the up-state and the down-state, but an expected alpha
of 100 basis points (bps) per annum, then Exhibit 2
shows the reservation price for two different risk premiums0 bps and 250 bps.
Exhibit 2 shows that the more confident an investor
is in a mangers ability to deliver a particular set of alphas
and betas, the higher the fee the investor will be willing
to pay. Again, the investor would prefer to pay less than
this fee. The fee derived is the maximum such that all
the investors surplus is consumed.
Using the same framework, assume a manager is
expected to have a zero alpha, but a beta of 1.0 in up
markets and a beta of 0.9 in down markets (e.g., this
ref lects downside risk management).
In general, asymmetric beta exposure can be
very valuable to an investor. This should be intuitively
obvious because it means a form of return enhancement on the upside and loss prevention on the downside.
Asymmetric beta exposure can be as valuableif not

more valuablethan delivering alpha.
This discussion of maximum fees ignores the additional services that the investor may receive by virtue
of investing with that particular manager: the ability to
transfer into other investments at no, or a reduced, cost;
recordkeeping or reporting services; and so forthall
of which are valuable. These other serviceswhich
are sources of valueshould be approximately equal
to the actual fees on passive alternatives. Because passive alternatives have no active management, the fees
on the passive alternatives should ref lect the value of
these additional services, provided the market for passive
management is adequately competitive.
An investoror an investors financial planner or
advisorneeds to develop expectations about what the
upside and downside opportunities are in a given market
environment. Then, based on expectations about how
portfolio managers will behave in those environments
(as measured by alphas and betas), a determination can
be made about how valuable a portfolio manager will be
to an investor. This creates an ex ante investor surplus.
A consistent manager can extract more of the investor
10/11/11 6:01:55 PM
Exhibit 2
Reservation Expense Ratio with Varying Degrees of Uncertainty
Note: These are the fees that would completely consume the investors surplus. Investors need to pay less than these to get an investor surplus.
Exhibit 3
Maximum Expense Ratio and Asymmetric Beta When Varying Uncertainty Exists around the Ability
to Deliver Asymmetric Beta
Fall 2011
10/11/11 6:01:59 PM
surplus than an inconsistent manager, as shown by the

risk premium. Even if an active manager is not equally
valuable in all market environments, the investor (or his
or her financial advisor) can actively manage the active
managers that are used in a portfolio.
Conclusion
A manager can add value to a portfolio in ways

other than simply picking winning stocks and avoiding
losing stocks. A manager can add value to a portfolio
through exploiting inefficiencies in index construction,
accessing markets for clients at lower transaction costs
than the individual investor can access them, and perhaps
even by picking a better portfolio than what an investor
would have chosen on her own.
Value, however, is different from price. Value is
how much a manager is worth to an investor, and price
is what is actually paid. The value of a manager is subjective and contextual. Value depends on the investors
perception of upside and downside opportunities in the
market. Even if a manager does not beat a particular
benchmarkwhich is a retrospective assessmentthat
does not mean that it was notprospectivelyvaluable
to invest with the manager.
The framework that I have outlined in this article
shows how, in addition to the administrative value added
to a portfolio, a portfolio manager can create investor
surplus. Investor surplus is created when an investor is
willing to pay more for a portfolio managers services
than he actually paysmuch like how consumer surplus
arises when a consumers reservation price exceeds the
market price. This article shows that a portfolio manager can create investor surplus through creating alpha,
through delivering asymmetric exposure to the markets
(for example, downside risk management), or through
consistent behavior.
There is a lot of room for future research related
to this concept of investor surplus. Because investor surplus is predicated on the concept of a reservation price
for investorswhich is derived in this articleinvestor
expectations could be better modeled. Additionally, the
idea of how to assign a risk premium to a managers
behavior in asymmetric markets can be better developed. I hope, however, that I have shown in the article
that investing with a portfolio manager should be evaluated along the lines of an experience good instead of a
simple commodity.
Endnotes
The views expressed are as of May 7, 2011, and are those
of the author and not those of Wells Fargo Funds Management, LLC. The views are subject to change at any time in
response to changing circumstances in the market and are not
intended to predict or guarantee the future performance of any
individual security, market sector, or the markets generally.
Wells Fargo Funds Management, LLC, is a registered
investment advisor and a wholly owned subsidiary of Wells
Fargo & Company.
NOT FDIC INSURED NO BANK
GUARANTEE MAY LOSE VALUE
Merton [1981] showed how, in a capital asset pricing
model and rational expectations framework, to value a manager
as a protective put on a portfolio. There have been numerous
papers outlining how to value multi-asset options or options
with variable maturity dates and f lexible characteristics; see
Johnson [1987], Rodriguez [2002], and Ronn and Bliss [1994].
In this article, I build on those insights to show how portfolio
management is valuable, at least in a subjective sense.
2
This, of course, assumes the investor is not investing
through an investment company, which has a fiduciary duty
to vote on corporate governance issues in the best interests
of the shareholders.
3
The Peltzman Effect refers to a situation in which a
safety device alters the behavior of the user such that the
efficacy of the device is undermined. A simple example is
when driving with an airbag makes people drive more recklessly, causing more accidents. In investing, the safety device
(diversification) alters investor behavior by causing indifference toward any given corporate issue. That indifference can
lead to more systematic risk.
1
References
Chen, H., J. Narasimhan, and R. Wermers. The Value
of Active Mutual Fund Management: An Examination of
the Stockholdings and Trades of Fund Managers. Journal
of Financial and Quantitative Analysis, Vol. 35, No. 3 (2000),
pp. 343-368.
Chen, R., S. Chung, and T. Yang. Option Pricing in a MultiAsset, Complete Market Economy. Journal of Financial and
Quantitative Analysis, Vol. 37, No. 4 (2002), pp. 649-666.
Clarke, R., H. de Silva, and S. Thorley. Portfolio Constraints and the Fundamental Law of Active Management.
Financial Analysts Journal, Vol. 58, No. 5 (2002), pp. 48-66.
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Ferguson, R., and D. Leistikow. Valuing Active Managers,

Fees, and Fund Discounts. Financial Analysts Journal, Vol. 57,
No. 3 (2001), pp. 52-62.
Grossman, S., and J. Stiglitz. On the Impossibility of Informationally Efficient Markets. American Economic Review, Vol.
70, No. 3 (1980), pp. 393-408.
Johnson, H. Options on the Maximum or the Minimum of
Several Assets. Journal of Financial and Quantitative Analysis,
Vol. 22, No. 3 (1987), pp. 277-283.
Keim, D. An Analysis of Mutual Fund Design: The Case of
Investing in Small-Cap Stocks. Journal of Financial Economics,
Vol. 51, No. 1 (1989), pp. 173-194.
Merton, R. On Market Timing and Investment Performance, Part I: An Equilibrium Theory of Value for Market
Forecasts. Journal of Business, Vol. 54, No. 3 (1981), pp.
363-406.
Peltzman, S. Toward a More General Theory of Regulation. Journal of Law and Economics, Vol. 19, No. 2 (1976), pp.
229-263.
Rodriguez, R. Lognormal Option Pricing for Arbitrary
Underlying Assets: A Synthesis. Quarterly Review of Economics
and Finance, 42 (2002), pp. 577-586.
Ronn, E., and R. Bliss. A Nonstationary Trinomial Model
for the Valuation of Options on Treasury Bond Futures Contracts. Journal of Futures Markets, Vol. 14, No. 5 (1994), pp.
597-617.
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Journal of Economics and Business, Vol. 56, No. 4 (2004), pp.
331-346.
Shukla, R., and C. Trzcinka. Performance Measurement of
Managed Portfolios. Financial Markets, Institutions & Instruments, Vol. 1, No. 4 (1992), pp. 1-58.
Stevens, J., and M. Finn. Investment Performance of an
Extreme Value Market-Timing Approach. Journal of Financial Planning, Vol. 3, No. 1 (1990), pp. 28-35.
To order reprints of this article, please contact Dewey Palmieri
at dpalmieri@ iijournals.com or 212-224-3675.
Fall 2011
10/11/11 6:01:59 PM

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Does Active Management

Provide Investor Surplus?

rice and value are two different things

add value is based on an ex post analysis, but

An Index versus a Benchmark

A further problem with purely passive investing is

Problems with Passive Investing

Passive investing can make sense if the individual

The Value of Active Portfolio

Shukla [2004] compared the returns on mutual

132 Does Active M anagement Provide Investor Surplus? Fall 2011

of the loss to investors could be a form of compensation

The use of risk-neutral valuation is ordinarily

enriches the service providers and the managers, but

trading strategy, or from the use of active managers. For

Equation (1a) simply says that $1 invested in the

the column vector of synthetic probabilities, UD . From

Now, I want to evaluate the maximum amount

The managers maximum-value expense (akin to

134 Does Active M anagement Provide Investor Surplus? Fall 2011

The investor surplus can be thought of as the

If a managers up-beta and down-beta are identical,

states. The uncertainty around those anticipations can

(rSU r f rp ) U (r f + rp rSD ) + D (rSD r f rp )

(1 + r f + rp )(rSU rSD ) + (rSU r f rp ) U (r f + rp rSD ) + D (rSD r f rp )

Again, the investor will be willing (and happy)

The preceding model assumes that the investor has

Up-State: TR = 1.017 0.069 TMR + 0.537 EY

Down-State:: TR = 4.600+ 0.140 TMR 0.067 EY

The coefficient of determination for each model

The Journal of Portfolio M anagement 135

Modeled Expectations of Up and Down Returns

the t-values are not statistically different from zero at

Asymmetric beta exposure can be as valuableif not

136 Does Active M anagement Provide Investor Surplus? Fall 2011

Reservation Expense Ratio with Varying Degrees of Uncertainty

The Journal of Portfolio M anagement 137

surplus than an inconsistent manager, as shown by the

A manager can add value to a portfolio in ways

138 Does Active M anagement Provide Investor Surplus? Fall 2011

Ferguson, R., and D. Leistikow. Valuing Active Managers,

The Journal of Portfolio M anagement 139

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