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Sharks needed in the tank

Dan Purves




Investors and consultants should be aware of the ownership fraction held and traded by active managers versus passive managers as this can have a significant effect on markets, new research has shown.

If there is an excess of passive mangers, long-term anomalies of pricing are enhanced, and if there is an excess of active managers, short-term problems of liquidity are enhanced, said Professor Russ Wermers of the University of Maryland, giving insights into his latest research.

“It is very clear, and most of us have the intuition, that we need both the sharks [active managers] and the prey [passive managers]. Forgive me – because that’s a bit too harsh because it’s a symbiotic relationship more than a predator prey relationship – [but] we need both in the water to make the world go round properly,” he said.

Wermers – whose bio describes him as an international expert on investment management with particular expertise in the efficiency of securities markets – was addressing delegates in a session called ‘Active vs Passive Investing and the Efficiency of Individual Stock Prices’ at a Centre for International Finance and Regulation’s (CIFR’s) conference on Tuesday.

He added as markets have grown more efficient, the number of active managers needed for a level of equilibrium is shrinking because there is less need for price discovery.

“This is conjecturing beyond my study, but this could be behind the move towards greater levels in indexing that we are seeing out in the marketplace, as prices become more efficient as technology and communication makes research more efficient and less costly,” Wermers said.

The worth of price discovery is also addressed in Keith Ambachtsheer’s book The Future of Pension Management, in which he argues that the cost of price discovery could be further reduced by billions of dollars.

In a thought experiment, he calculates that if 150 idealised institutions in the US (each managing $100 billion) spent $75 million each on internal security analysts, that optimal cost works out to about $11 billion per annum, or 7.5bps in relation to the $15 trillion market portfolio.

“That is one-tenth of the actual 77bps or $115 billion spent [in the US equities market] in 2006,” Ambachtsheer said in the book.

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    Wermers’ research also found that the stock holdings and trades of active and passive managers were highly correlated, but caveated this was not to an “incredible” extent.

    “This is back in the predator prey model. You are going to find the predators where the prey is. If a stock is held pretty heavily by active fund managers it is held pretty heavily by passive fund managers, and vice-versa,” Wermers said.

    “If a stock is traded pretty heavily by passive fund managers then it’s going to be traded pretty heavily by active fund managers, but that doesn’t mean they are going to be trading in the same direction. The sharks are going to eat the prey; they are not going to swim with the prey.”