Why Might Investors Choose Active Management?

F. Douglas Foster*, Geoffrey J. Warren

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

5 Citations (Scopus)

Abstract

We investigate why investors may be willing to participate in active management, notwithstanding expectations for negative average alpha after fees across all managers. Our approach involves modeling the expected outcome from investing in a portfolio of active managers, for investors who believe they have ability to select good managers and may anticipate benefits from replacing managers when alpha expectations fall. Numerical calibrations using inputs consistent with the literature find that certain investors can credibly invest through active managers at observed fee levels, most notably institutions. However, participation in active management at fees paid by some retail investors can only be explained by allowing for behavioral biases. Our analysis suggests that the wide use of active management reflects a diversity of investors who form expectations based on information other than expected alpha for the average manager, some of which entails cognitive error.

Original languageEnglish
Pages (from-to)20-39
Number of pages20
JournalJournal of Behavioral Finance
Volume16
Issue number1
DOIs
Publication statusPublished - 2 Jan 2015
Externally publishedYes

Keywords

  • Active management
  • Behavioral finance
  • Bounded rationality
  • Expectation formation
  • Manager selection

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