In active versus passive management, Dr. Myron Scholes explains that it’s the constraints on others that allow active managers to earn excess returns.

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There’s a debate among advisors and among investors as to whether active management or passive management is the right place to put money. So, that has come about in part because of the great growth in ETFs and in part because of the average inability of active fund managers to outperform benchmarks.

I think that the debate, however, is centered on the wrong question. The debate is centered on performance measurement. The debate is centered on whether a fund manager can outperform a benchmark, and a lot of that performance benchmarking constrains the managers to stay close to the benchmark. For example, Morningstar will rate a manager lowly if they deviate too far from the benchmark. And the question as an investor, the investor should raise, is not whether they’re close to the benchmark, or how well they do relative to the benchmark, because that relative performance, it doesn’t really bring home the bacon in the sense that it’s absolute performance that has the most important effect on an investor.

My view of investment has been that there’s a right way to try to generate alpha and an incorrect way to generate alpha. My thinking is that if you have, if you think about investment as this relative performance to a benchmark, and you’re too close to the benchmark, then you’ll stay very short term in your focus to generate alpha. If, on the other hand, because of the constraints of so many investors to stay close to the benchmark, the active investor has a theme, an underlying theme that they understand, people who are constrained can’t use that theme, then they can outperform. So, really, in investment management it’s the constraints, the constraints of others that allow you to make excess return. So if an investor is, or many investors are stuck close to the herd, close to the benchmark, and because the active manager has the trust of his clients, he can, or she can then deviate from the benchmark and take tracking error, and they have faith in their long-dated themes, they can make excess returns.

The interesting thing, if you look at the very popular index fund, it has no tracking error, so that’s great, it’s highly constrained to be by itself. Two, it has very low fees, no fees or very low fees. But it has no risk management, so the risk of the S&P 500 in 2007 and 2008 was much different from the risk of the S&P 500 in this last six to 12 months, and obviously in 2012 the risk of the S&P 500 was much greater in the first few months than it is now. So the risk is always changing.

A story that I like to tell people is the movie The Titanic. Everyone in the upper decks of the Titanic were drinking and having a good time and dancing and listening to music, while those on the lower decks of the Titanic obviously were suffering and dying. So, relatively, those people on the upper deck of the Titanic actually were much better off than those on the lower deck of the Titanic. But as this picture shows the most important thing is not relative performance or relatively where you are, but absolutely they were not in very good shape. So the fundamental question if you’re constrained to stay at the benchmark, you don’t ignore risk but if you’re not constrained and you will trade tracking error, you can earn rewards by deviating from the benchmark.