BAFI6010 · Advanced Investment Management
Passive and Active Investment Strategies
This topic is the active-versus-passive debate that BAFI 6010 grounds in two named papers you must argue in the exam: Sharpe (1991) — before costs the average active dollar earns the market, so after costs it must underperform a cheap index — and Berk (2004) — capital flows compete away the investor's alpha, so skill accrues to the manager as fees and AUM, not to the investor as persistent outperformance. It also covers the 5-step process for building a strategy (philosophy, signal, capture, implement, review), the SRY / Fed-model worked strategy, and rebalancing regimes (buy-and-hold, constant mix, CPPI). Because roughly 80% of the final rewards discussion, correctly named arguments earn more marks than any single calculation here.
What this chapter covers
- 011. Active vs passive & the EMH paradox — active adds no value if markets are perfectly efficient, yet markets need active investors for price discovery; active bets = stock selection + market timing
- 022. Manager signatures — benchmark (TE 0, alpha 0), passive (minimise tracking error, ~0 alpha), active (deliberate tracking error targeting positive alpha, higher fee and volatility)
- 033. Sharpe (1991) arithmetic — before costs the average active dollar = the market; after costs it must fall below it; a negative-sum game net of fees
- 044. Berk (2004) capital flows — flows to skill, then AUM growth, then diseconomies of scale drive net investor alpha back toward the benchmark; skill is captured as AUM not persistent alpha
- 055. Edelen-Evans-Kadlec (2007) mechanism — trading costs exceed the expense ratio, are negatively correlated with performance and hit larger funds harder, producing closet indexing as funds grow
- 066. The 5-step process — philosophy, signal creation, capturing the signal, implementation, feedback/review, with the value-added-versus-capacity trade-off
- 077. The SRY (Significant Relative Yield) model — bond yield / equity earnings yield with a plus/minus 2 sigma signal rule; a high ratio sends you to bonds, a low ratio to stocks
- 088. Rebalancing regimes — buy-and-hold (linear), constant mix (contrarian, concave payoff), CPPI (trend-following, convex payoff with a floor)
Net alpha and the Berk (2004) decay
- +1Active net alpha = gross alpha minus the active fee: 1.8% - 0.85% = +0.95% (gross of the passive fee).
- +1Passive alternative earns approximately the benchmark minus its own fee, so about -0.10% of alpha.
- +1Today's verdict: active looks attractive — a +0.95% net alpha beats the passive -0.10%, IF the 1.8% gross alpha is genuine and repeatable.
- +1Berk (2004) dynamics: that visible net alpha attracts inflows; as assets under management grow the fund meets diseconomies of scale and rising trading costs, so gross alpha falls.
- +1Equilibrium: flows continue until the investor's net alpha decays toward the benchmark (approximately zero) — the skill is captured by the manager as fees and AUM.
- +1State the punchline: the manager may be genuinely skilled, yet the average investor's net excess return converges to about zero — consistent with efficient markets for investors.
Key terms
- Passive management
- A strategy that takes the market return as given and replicates a benchmark at the lowest possible cost, deliberately minimising tracking error so that both tracking error and alpha stay near zero.
- Active management
- A strategy that deviates from the benchmark on purpose to earn active return (alpha), through stock selection (over-weighting under-priced securities) and market timing (tilting toward asset classes before they rise).
- EMH paradox
- If markets were perfectly efficient, active management could add no value — yet markets cannot become efficient without active investors doing price discovery, so some active management is necessary.
- Sharpe (1991) arithmetic
- Because all investors together hold the market, the average actively managed dollar must earn the market return before costs and therefore underperform a cheap index after costs — active management is a negative-sum game net of fees.
- Berk (2004) capital flows
- Money chases the best manager, growing AUM until diseconomies of scale drive the investor's net alpha back to the benchmark; the most-skilled manager ends up with the most money, not the highest persistent outperformance.
- Closet indexer
- A fund that charges an active fee but hugs its benchmark (high R-squared, tiny tracking error), so investors pay for active management and receive passive-like delivery.
- SRY / Fed model
- The Significant Relative Yield strategy: compare the bond yield to the equity earnings yield and bet on mean reversion — a ratio above mean + 2 sigma sends you to bonds, below mean - 2 sigma to stocks, otherwise 50/50.
- Rebalancing regimes
- Buy-and-hold does nothing after the initial mix (linear payoff); constant mix rebalances to fixed weights (contrarian, concave); CPPI holds a floor and buys risk as the cushion grows (trend-following, convex).
Passive and Active Investment Strategies FAQ
Are Sharpe (1991) and Berk (2004) actually examined?
Yes — the course names both papers and expects you to argue them. Sharpe (1991) gives the arithmetic (before costs = the market, after costs below it); Berk (2004) gives the equilibrium mechanism (capital flows compete the investor's alpha away and it decays to the benchmark). Learn each as a one-line mechanism you can apply to a fund in the exam.
What is the single most common trap on this topic?
Confusing 'no net alpha for investors' with 'no manager skill'. Berk's point is that skill is real but is competed away from investors by flows and captured by the manager as fees and AUM. The other frequent slip is flipping the SRY signal — a high bond/earnings-yield ratio means equities look expensive, so you go to bonds, not stocks.
How is Topic 5 assessed?
It is examined in both the closed-book mid-semester test (which covers Topics 1-5) and the final exam (which covers all topics except Testing Portfolios). It is mostly short-answer discussion, so naming the papers and laying out the 5-step process cleanly is worth more than any single calculation.
Does Sharpe (1991) mean active management is always wrong?
No. It means the average active dollar must lose to a cheap index after costs, because active managers can only beat the market at each other's expense while the group still pays the costs. Skilled managers exist; the practical takeaway is to control the one variable you can — costs — and demand enough gross alpha to clear the fee before going active.
Which rebalancing rule is best?
There is no universal winner. Constant mix is contrarian with a concave payoff and shines in choppy, range-bound markets; CPPI is trend-following with a convex payoff and downside protection and wins in strong sustained trends or when you need a floor. Recommending one without a market view or a floor requirement loses the judgement mark.
Is this page official or affiliated with the University of Adelaide?
No. This is an independent AskSia study resource to help students revise. It is not produced, endorsed by, or affiliated with the University of Adelaide, and it is not a substitute for the official course materials and Canvas announcements.
Exam move
Treat this topic as a discussion chapter first and a calculation chapter second. Memorise the two named papers as crisp one-liners — Sharpe (1991): before costs the average active dollar equals the market, after costs it must underperform, by arithmetic; Berk (2004): flows compete the investor's alpha away so skill shows up as AUM, not persistent outperformance — and practise applying each to a concrete fund. Learn the manager-signature table (benchmark, passive, active on tracking error and alpha) so you can reproduce it from memory in the mid-semester test, and rehearse the 5-step process with the value-added-versus-capacity trade-off that the SRY example illustrates. Drill the net-alpha calculation until it is automatic, then always follow the arithmetic with the Berk decay in words. Because the exam penalises over-answering, practise picking the two or three most decisive points rather than listing everything, and work past-style short-answer questions under timed, closed-book conditions during the revision week.
