It seems to have become a financial axiom that actively managed mutual funds fail to justify their fees.  Ergo, index funds are often proposed as the best way to lose the least amount of money.

But what if the underperformance of actively managed funds has been driven by their underlying strategy, not their stock-picking buffoonery?

Beneath the complexity of their recent paper on benchmark indices, that’s the question posed by Martijn Cremers and Antti Petajisto of Yale and Eric Zitzewitz of Dartmouth. (You may recall the names Cremers and Petajisto from their paper on active share – a new metric to measure active management.  See related posting.)

The researchers found that academic models aimed at isolating manager skill by adding new variables to the CAPM (such as the Fama/French and Carhart models) are a substantial weakness.  Instead, they propose using actual indices as variables in an equation to reveal manager skill.

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