Bridge over ocean
1 November 1979 Financial Analysts Journal Volume 35, Issue 6

Can Active Management Add Value?

  1. Keith P. Ambachtsheer
  2. James L. Farrell

To survive the onslaught of passive management, active management must produce returns large enough to offset its higher risks and fees. The authors identify the basic building blocks of a viable active management approach, shed light on the kinds of results that can be expected when these building blocks are integrated into an active management process and suggest some reasons why active management, although viable in theory, has often failed to outperform passive management in practice.

The five basic building blocks of active management are (1) judgments on the degree to which securities are under- or overvalued, (2) assessments of the correlation between these judgments and subsequent security returns, (3) conversion of the judgments into expected returns that are both unbiased and scaled to reflect the judgments’ predictive power, (4) portfolio building rules that generate changes consistent with diversification requirements, transaction costs and legal and other considerations and (5) a mechanism for translating portfolio changes into actual buy and sell orders.

Tests suggest that existing research approaches are capable of generating judgments with low but significant predictive power, and that a combination of approaches will often yield results superior to those of any one approach. Superior results are forthcoming, however, only when the active manager devotes adequate attention to building blocks (2) through (5).

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