Morningstar Magazine - December/January 2015 - 71

Bill Sharpe wrote a paper 20-some-odd years ago,
called "The Arithmetic of Active Management,"1
where he pointed out that passive managers are
out of the game because they basically hold
cap-weighted portfolios and they don't respond to
active managers. So, if active managers win,
it has to be at the expense of other active
managers. And when you add them all up, the
returns to active management have to be literally
zero before costs. After costs, it's a negativesum game.
So the question is, when is active management
good? The answer is never. Because it's
always a zero-sum game. It's not sometimes it is
and sometimes it isn't. That's a really difficult
perspective to get people to accept.
Johnson: But is there a theoretical limit to all of this,
as you describe?

Fama: Yeah, theoretically. Ken French and I
have a paper that says, "Theoretically, you need
one investor with a tiny amount of wealth
who is informed about everything and will not
trade until prices are correct." That's enough to
make the market efficient. [laughter]

Eugene Fama says his efficient markets theory was
"a simple concept" that survived emperical testing.

Johnson: So, that's what we need in the market:
one really smart active manager.

Fama: Right. With a tiny amount of wealth. That's
the mathematics. [laughter]
Johnson: Based on what the evidence shows us,
then, why do you think investors continue to
allocate so much money to high-fee managers and
active strategies?
Fama: I don't know, really. As far as individual

investors are concerned, they clearly are so much
better off buying passive products than they
are buying active products. It's really laughable.
For a professional investor-say a pension fund
manager-is he more likely to be able to tell
good from bad active managers? Well, Ken French
and I did a paper,2 and we said, "Let's look at

1 Financial Analysts Journal, January/February 1991, vol. 47,
no. 1, pp. 7-9.
2 "Luck versus Skill in the Cross Section of Mutual Fund
Returns," The Journal of Finance, October 2010, vol. 65,
issue 5, pp. 1915-1947

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Table of Contents for the Digital Edition of Morningstar Magazine - December/January 2015

Contents
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Morningstar Magazine - December/January 2015 - 1
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