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The never ending debate about the merits of active investment management vs passive investment management rages on. In a post Friday morning Josh Brown asked this important question:

How do we determine the "value" of active management?

I think there are two primary characteristics that define how valuable an active manager is. The first is strategy value. The second is alpha value.

Strategy value is a money manager's ability to add value through unique portfolio composition. The investment world is increasingly interconnected and blended by various approaches. The product line that Wall Street has produced over the years has become increasingly diverse and makes the options for portfolio construction that much broader. This is valuable in that we are then able to construct portfolios with varying correlations, risk levels and goals without having to be experts in specific individual security types or through having access to certain markets (which can be difficult in some cases). Importantly, we are no longer boxed in by our portfolio options that force us to pick one asset class or one strategy.

Unfortunately, most active managers mimic or copy a large correlated index of some type. There's zero value add in this approach in most cases. After taxes and fees a similarly correlated index will outperform these strategies because they're essentially the summation of the index they're copying. By definition, they must underperform.

But there's huge value in an approach that gives investors access to something that they can't otherwise access through a broadly distributed index fund. I used to use an event driven strategy when I ran my investment partnership. I generated sizable risk adjusted returns with no negative full year returns during a 7 year period (in one of the most difficult environments in investment history). If there had been an index that replicated my strategy I would have had a hard time outperforming it. But there wasn't (isn't). So my value add was through my approach. I was giving my investors access to a unique strategy that helped them diversify their own portfolios through strategy value.

Of course, the strategy has to be valuable itself. This is where alpha value comes in. Alpha value is the ability of an active manager to generate high risk adjusted returns through their approach. Most active managers can't generate alpha because their approach is essentially some form of closet indexing. In other words, large cap value funds don't generate alpha because they tend to just copy the S&P 500. Their risk adjusted returns are weak and even weaker after taxes and fees. The average investor doesn't even begin to study the importance of this when picking funds or managers. And the managers don't want you to understand it because they want you to think that their fund is better regardless of a fair apples to apples comparison. How else could they justify the higher fee?

Of course, the key here is actually finding the active managers who can add value in one of these two ways over long periods of time. Easier said than done, but they're out there.

Source: Evaluating The Value Of Active Management