How Does Bill Sharp's Arithmetic of Active Management Work?

The equilibrium, zero net alpha fit in the framework of Bill sharp's arithmetic. The only way active managers could make money is that they take it away from everybody else. But there are lots of investors getting in every month and getting out every month. An active manager that trades against those people will also win,. because they have an informational advantage.

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Do you feel like you have a good grasp of financial markets? Think again! In this episode, we take a plunge into the world of financial markets with experts Jules van Binsbergen and Jonathan Berk. Jules is a Professor of Finance at the Wharton School of the University of Pennsylvania and Jonathan is a Professor of Finance at Stanford Graduate School of Business. They also host a popular podcast called Else Equal, which explores the science and strategy of making better financial decisions, and have written several academic papers that challenge the status quo. In our conversation, we discuss their research on the relationship between manager skill and fund performance, the best ways to measure performance, and reasons why benefits are in favour of the managers. We also explore the dogma surrounding mutual funds, the differences between active and passive management, and how to measure efficient capital markets. Listeners will also hear perspectives that challenge their understanding of capital markets and viewpoints that completely disagree with previous guests. Although we have covered this topic before in previous episodes, this conversation will fundamentally change the way you view financial markets and how to think about them.

Key Points From This Episode:

What information fund performance contains about manager skill. (0:04:04)
Reasons why manager skill and performance are unrelated. (0:04:59)
We learn how manager skills should be measured. (0:06:57)
How to choose the appropriate benchmark to measure value added. (0:09:26)
Find out if you can use factor-mimicking portfolios to measure risk-adjusted returns. (0:12:05)
Whether funds that directly target risk factors can be used as an investable benchmark. (0:16:35)
What the skill of active managers are when skill is measured as value-added. (0:20:52)
The proportion of value-added between security selection and market timing. (0:23:20)
Discussion about how persistence manifests when it is measured by value-added. (0:25:43)
Find out if investors should analyze mutual fund companies as opposed to managers. (0:32:36)
Discover why research has focused on individual security pricing and not on evaluating manager skill. (0:34:25)
We unpack the reasons why it's a zero net alpha as opposed to a negative net alpha in equilibrium. (0:38:19)
We delve into why the research took so long to apply rational expectations to fund investors as with the stock market. (0:42:46)
An explanation of how equilibrium zero net alpha fits into Bill Sharpe's arithmetic of active management. (0:48:16)
Who benefits from the high amount of skill available within the sector. (0:51:11)
Whether the increase in millionaires around the world drives inequality. (0:56:12)
Hear if it is possible to identify skilled fund managers before the benefits of their skills are absorbed by fund size. (01:01:41)
The implications on efficient market hypothesis for the stock market. (01:05:36)
Advice for investors, considering that the benefits of skill are in favour of managers. (01:08:37)
Details about their research on how multi-factor asset pricing models are not representative of risk. (01:12:45)
We end the show by learning how our guests define success in their lives. (01:19:08)