Fuqua Insights Podcast: Why Is Active Investing Important for the Economy?

Tanner Morgan 0:03  
Welcome to Duke Fuqua Insights, a podcast where we explore faculty research and the actionable takeaways for business leaders at every level. Many investors grapple with whether active money management is worth the cost. It’s a fair question, considering most funds underperform the market after fees—but the impact is actually much deeper than that.
I am Tanner Morgan, a recent Fuqua MBA graduate, and my guest today is Professor Simon Gervais. He is a financial economist, and his research explores investment behavior and corporate decision-making, including a recent study that goes beyond the usual debates about mutual fund returns. Research shows that active managers may still be good for the economy, despite not beating the market. But why? Because they help firms make better investment decisions, which ultimately boost economic productivity and firm value.
Thanks for being here, Professor.

Simon Gervais
Thank you for having me here.

Tanner Morgan  
So let's start with what motivated you to pursue this study. The debate around active versus passive money management has been examined for decades—something we talked about in class. What inspired this specific research?

Simon Gervais  1:16  
Actually, it’s literally something I talk about in class. It’s always in every single course that I’ve taught in MBA programs—not just at Fuqua, but everywhere else. The second or third slide is always trying to convey why finance is important, and it’s about the allocation of capital.
So what is the main role of finance? It’s about allocating capital efficiently. And what struck me is that when we talk about money management, that function was never discussed. So it’s as if these money managers are completely outside the capital allocation process. They just observe. They just get returns from securities. Some are good at identifying good returns, and some are not as good at doing that.
And I thought, well, maybe there’s a function that we’re not talking about, and then let’s try to put the two together. That’s kind of the idea.

Tanner Morgan 2:11  
So tell us a little bit about your model feedback loop, where firms adjust their investment strategies based on stock prices that incorporate information from active managers. What did you find?

Simon Gervais  2:23  
So the general idea, the starting point of the paper is to say that money management as an industry as a whole, they have, they possess information that managers may not have. It may be about the direction of the economy, maybe about industries, how competition is going to happen. So we're not assuming that obviously the CEOs don't know anything about their firm. We're well aware that they know a lot about those, but it is possible that money managers know something that these CEOs or executives don't know. And so the idea then is that, well, the money managers will trade based on this information, and this will come to affect prices. And of course, the way prices move will inform the money man, the CEOs and the executives, will inform the firms in general, about what these money managers think, and so they may see, well, a good example would be, all right, we announced the merger, our stock went down. Maybe that was a bad idea. So that's kind of the idea that we have in this paper.

Tanner Morgan 3:30  
So was there a moment during the research process where you realized you were seeing something new or even surprising that challenged the conventional wisdom?

Simon Gervais 3:40  
So the main thing that we realized reasonably early on, but that we hadn't fully anticipated, and that created a lot of problems because we didn't know exactly how to model it—but the main idea was the fact that to measure the performance or the contribution of money managers, you cannot just focus on returns. So essentially, you need to think about risk, and you need to think about how investors can absorb that risk and the kind of utility they will get from their positions. So essentially, high returns may be good, but the risk that comes with them needs to be ascertained and measured and incorporated in the measure of the contribution of this activity.

Tanner Morgan 4:25  
I want to dig a little deeper into the concept of returns. So you showed that even if a fund has a negative net return, investors might still be better off. More broadly active money managers can improve the economy, is what you're saying. How is that possible?

Simon Gervais 4:42  
I think the easiest way to communicate the idea would be the following. Suppose there are only two industries. Let’s call them software and automobiles, okay? And investors think that they don’t know whether automobiles should get 60% of the capital or 40% of the capital, with software getting the rest. So essentially, they’re unsure about that.
If they’re unsure, what are they going to do? They’re going to go in the middle. So they’re going to do 50–50—they’re going to allocate their capital equally.
Now suppose there’s one person in the economy, or one group of people. In fact, I’m going to call them Tanner for the purpose of this interview. Suppose Tanner knows whether it’s 60–40 or 40–60, and suppose you’re willing to take investors’ money and do that allocation for them. If you charge us very little money, we’re going to be very attracted to that proposition, because you’re going to do well with our money—and so will all the investors.
Let’s assume that a large majority of investors go to you, or to the money management industry in general, and we do that. So what happens then? Well, if you think about the way we usually measure the performance of money management, we just look at performance minus the market. Well, you’re the entire market at this point, so what we call alpha—the extra performance—is exactly zero in that model. Because you charge us fees, your performance after fees is below zero. So you generate a negative alpha.
Now, are we better off? Well, possibly, because what you’ve done is allocate capital in a much more effective way. So the economy is bigger. Even though we get less in terms of returns, we still get a bigger economy, and we get more utility out of it. That’s the idea.

Tanner Morgan 6:34  
So even if investors who don't use active managers can benefit from more efficient capital allocation, why would they take on the risk? Is it fair to say that passive investors are maybe even getting a free ride?

Simon Gervais 6:48  
Here’s the problem—and this is what’s very subtle in the model. This is essentially what the paper points out: passive investing is going to be a bit late to the game.
In the example I gave you, I go 50–50 because I don’t know. If I give you my money now, suddenly I can adjust. When software becomes more productive, my position is going to adjust properly. So that’s kind of the idea in that model.
The other thing that comes out of this model is that if you adopt a pure passive strategy—where you say, “All right, I’m going to invest in a broadly diversified set of stocks”—what’s going to happen is that you don’t look anymore. You just say, “I’m going to sit back and relax and just do this,” as we often teach in an intro course.
But what this model points out as a trade-off is the following: some of the companies that experience positive shocks and receive good information are going to grow bigger and bigger and take on more and more risk. Your risk exposure is not going to adjust. So if you think about your own position, yes, you may benefit from the returns, but you may be hurt by the fact that you’re not really adjusting your position for risk.

Tanner Morgan 8:03  
You spoke about getting a smaller slice of a bigger pie. That's something you just said. What's your advice for MBAs on how to think about value creation versus value capture, especially in finance?

Simon Gervais 8:15  
Actually, what I loved about this paper is that it kind of brought me back to essentially… so obviously, our focus in finance is about the efficiency of financial markets and how we can think about those markets. But ultimately, what this pointed out is that there's a labor market as well, and labor markets operate effectively. So in the model, actually, it's not automatic that we will hire you directly. We're only going to hire you if it makes us better off, or at least not worse off. Okay, so essentially, what happens is that the value that you create, you're going to benefit from it. And that's kind of the way I relate to your question, is that ultimately, what it reminded me of is that the way labor markets operate is that if you create value somewhere, you're going to get compensated for it somehow. And so, just like in fact—an example I use in class is that while there are good plumbers, there are bad plumbers. The good plumbers tend to get more money. And that's kind of the idea of this. So ultimately, it reminded me that creative MBAs, creative workers in general, will reap the benefits of their creativity.

Tanner Morgan 9:27  
What does all of this mean for how we evaluate or even regulate active money management? Are the current performance standards or metrics outdated?

Simon Gervais 9:36  
And this is kind of where the surprise comes in that you mentioned a little bit earlier. What I think is missing from the way we look at money management is the impact that this activity has on the productivity of the economy.
The perfect experiment to measure how useful that activity is would be to eliminate it for a little while and see how much worse off we are. We could then look at the difference and say, “All right, this is how much better off we are.” Obviously, that experiment cannot be implemented.
My hope is that with newer techniques—what we call structural models—we can estimate what would happen in a counterfactual world where we don’t have these activities, or where we have certain regulations in place. In that way, we can estimate, at least approximately, the value creation of that activity.
Now, to be fully transparent, this model is not quite there yet. We’re simply pointing out that there is a gap in how we look at the performance of money managers. The reason for that gap is that, yes, returns are important, but ultimately utility—how people handle risk—is also important.

Tanner Morgan 11:00  
One concept that we speak about in class is indices. So massive index funds like VTI or VOO, I think a lot of MBAs find these indices attractive. How does it relate to the active funds that we're discussing, or the active money management?

Simon Gervais 11:17  
Yeah, so that's a very interesting question, actually, not one I had really pondered before, but one could actually think of this model. The thing is, what comes out of this model is also the weights for the different—not just for the different companies—but also the different industries. So essentially, the weights are now, if you will, endogenous to use kind of economic lingo. Essentially, they depend on how big a company is, depends on what money management thinks about it and how big an industry is. They also depend on how kind of the money management industry thinks about it. So ultimately, these indices are not as exogenous as we thought they were. So it's not like, all right, we've got this industry, and we discussed this briefly also in our course, if you remember, because we talked about kind of the worldwide market portfolio, and we see how it has shifted over time. Software, obviously, 40 years ago was a tiny portion of it. Now it's a big portion of it. Obviously more capital has flown to it. And so that's kind of the idea that I think ultimately what we can do is combine what we do, what I do in this paper, and think about index creation that is somewhat more endogenous to that industry.

Tanner Morgan 12:40  
That's awesome. Well, Professor, looking ahead, do you think that new technologies like AI- driven funds or even alternative data, change the role of active managers, or does it just give them new tools?

Simon Gervais 12:52  
I think it's mainly new tools. But I will say the following: I think these are new tools that will probably benefit active money management more than passive money management. So I think that technology, if I think back going from the 80s through to the 21st century, was mainly about the use of technology and kind of setting up trading, and that benefited a lot the index funds, because they can automate how they'll trade, they can aggregate, they can cross trades within the fund. Now we've got exchange traded funds, and so those are clearly very relying on technology, but this is kind of what I would call old style technology. This is just about computing power, whereas this is more about… well, let's think about what we feed to these, to these AI engines, and let's think about what comes out of them to try to gain some advantage. I don't see passive investors benefiting from that very much more than that, the fees that we incur to invest in passive funds are so small that it's hard to see that they're going to get a lot better going forward, whereas for active money management, well, this gives them, like, as you said, new tools that they can use to kind of generate, or at least identify information that may be ignored by firms and that can be incorporated in the allocation of capital. At the same time, I will say the following, it also makes it easier for individual investors to compete a little bit. The difference, I think, and that's what's going to distinguish good from bad investors is what you feed these engines. It's not enough to just say, give me the good returns. It's going to be about: All right, here's what I think is going on. Let's think about this, and then understanding the output.

Tanner Morgan 14:53  
Sounds like everyone should take your course, hopefully. Well, Professor, thank you so much for joining me today.

Simon Gervais 14:59  
Thank you, Tanner. I really appreciate it.

Tanner Morgan 15:07  
Duke Fuqua Insights is produced by the Fuqua School of Business at Duke University. You can learn more at fuqua.duke.edu forward slash podcast