A window of opportunity for fund managers to outperfrom index funds, according to study

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Active fund managers could preserve more than 1.2% per year, net of fees, of outperformance versus passive index funds, according to analysis from Essentia Analytics. 
 
The research shows that active fund managers have a ‘window of opportunity' per position within which they can outperform index funds by a margin significantly greater than their active management fees.
 
The Alpha Lifecycle study, documented in two research papers, the second of which was released today, plots the average trajectory of each position in active managers' portfolios.  It found that, on average, the alpha generation of a given position tends to rise steadily early in its lifecycle, then plateau, then fall dramatically. On average, managers hold on to their stocks well past "peak alpha," selling at a point at which they have given up all of the position's outperformance. Essentia attributes this to the "endowment effect,'' whereby investors overvalue something by virtue of their ownership of it.
 
While this supports the notion that active managers, on average, tend to underperform their benchmark indexes, net of fees, the Essentia study further revealed that the alpha produced by active managers before it decays is well in excess of the fees they charge — over 1% a year in net performance. Therefore, active managers have the potential to deliver much better performance than index funds — if they have the insight and the discipline to exit their positions at or near the top of their alpha curve.  
 
Essentia's analysis defines the "windows of opportunity" within which managers can exit their positions and realize an index-beating return, net of fees. On a typical position held for one year, managers have about nine months to act and still produce net-of-fee gains above their benchmark index.  
 
The findings come at a tumultuous time for the fund management industry, in the wake of the Neil Woodford affair. Low- or no-fee index funds are increasingly seen as a more cost-effective option than active funds, in which managers attempt to beat the broader market indexes, for a fee. But the Essentia report shows that active managers handily outperform index funds — well in excess of their fees — early in the lifespan of their positions. The problem is, active managers tend to hold on to their stocks too long and the gains they made early on tend to diminish.  
 
"The active fund management industry is well aware that assets are flowing to index funds because fund managers have consistently underperformed their benchmark indexes," said former fund manager and Essentia Analytics CEO Clare Flynn Levy. "But from our research, we can see that this trend is neither inevitable nor unstoppable."
 
"This research challenges the active vs passive orthodoxy — which seems to assume that active portfolio managers cannot improve their performance — and fundamentally changes the discussion. It's no longer a given that passive fund investing is more cost-effective than active. It's now whether — and if so, how — active managers can realize the alpha we know they're generating before it decays away."

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