Active equity risk premium

What Is Active Equity Risk Premium?

The Active Equity Risk Premium (AERP) represents the additional return an actively managed equity portfolio seeks to generate compared to its specific benchmark index, after accounting for all associated fees. It is a core concept within Investment Management, reflecting the aspiration of active fund managers to outperform the broader market or a chosen segment by employing strategic decisions such as stock selection, market timing, or sector rotation. The AERP is distinct from the general equity risk premium, which measures the expected excess return of the overall stock market over a risk-free rate.

History and Origin

The concept of an active equity risk premium emerged intrinsically with the rise of active portfolio management, where professional Fund Managers aimed to deliver returns surpassing a passive index. Historically, active management was the predominant form of investing. However, the theoretical foundation for questioning its consistent ability to generate an AERP gained significant traction with the development of the Efficient Market Hypothesis (EMH). Pioneered by economist Eugene Fama in the 1960s and formally reviewed in his influential 1970 paper, "Efficient Capital Markets: A Review of Theory and Empirical Work," the EMH suggests that, in an efficient market, asset prices fully reflect all available information, making it difficult for active managers to consistently "beat the market"⁹. This theory implies that any positive AERP observed would primarily be due to luck or by taking on greater risk rather than genuine skill. The ongoing debate between advocates of active and Passive Investing continues to shape how investors view and pursue the AERP.

Key Takeaways

• The Active Equity Risk Premium (AERP) is the excess return an active equity portfolio targets above its Benchmark after fees.
• It quantifies the success of active management strategies in generating superior returns.
• Consistently achieving a positive AERP has proven challenging for the majority of active funds over longer periods.
• Fees, such as the Expense Ratio, significantly impact the ability of an active fund to deliver a positive AERP.
• The pursuit of AERP is central to the objective of active management, aiming to deliver Alpha.

Formula and Calculation

The formula for the Active Equity Risk Premium is straightforward, representing the net-of-fee outperformance:

Where:

• Active Portfolio Return: The total return generated by the actively managed equity portfolio over a specified period.
• Benchmark Return: The total return of the chosen benchmark index over the same period. The benchmark serves as the reference point for evaluating the active manager's performance in Portfolio Construction.
• Active Management Fees: All costs associated with managing the active portfolio, including management fees, trading costs, and other operational expenses, expressed as a percentage or in monetary terms.

Interpreting the Active Equity Risk Premium

Interpreting the Active Equity Risk Premium involves assessing whether an active manager has successfully delivered value beyond what a passive investment in the benchmark would have provided. A positive AERP signifies that the active portfolio has outperformed its benchmark after accounting for costs, suggesting the manager's investment decisions added value. Conversely, a negative AERP indicates underperformance, meaning the active strategy, net of fees, yielded less than a comparable passive investment.

For example, if an active fund returns 10% when its benchmark returns 8%, and the fund's fees are 1.5%, its AERP is ( (10% - 8%) - 1.5% = 0.5% ). A positive AERP of 0.5% suggests the manager added value. However, empirical evidence frequently shows that many active funds struggle to achieve a positive AERP consistently, often trailing their benchmarks, especially after fees⁸. This performance is often measured relative to factors like Beta, which indicates a portfolio's sensitivity to market movements, to determine if outperformance is due to skill or simply higher market exposure.

Hypothetical Example

Consider an investor, Sarah, who has $100,000 to invest in equities. She is evaluating two options for a year:

1. Passive Investment: An exchange-traded fund (ETF) tracking the S&P 500, with an expense ratio of 0.05%.
2. Active Fund: An actively managed large-cap U.S. equity mutual fund, with an expense ratio of 1.00%, aiming to outperform the S&P 500.

At the end of the year:

• The S&P 500 (benchmark) returned 12%.
• The actively managed fund returned 12.5%.

To calculate the Active Equity Risk Premium (AERP) for the active fund:

• Active Portfolio Return: 12.5%
• Benchmark Return: 12.0%
• Active Management Fees: 1.00%

AERP = ((12.5% - 12.0%) - 1.00%)
AERP = (0.5% - 1.00%)
AERP = (-0.5%)

In this hypothetical scenario, despite the active fund having a higher gross return than the benchmark (12.5% vs. 12%), its Active Equity Risk Premium is -0.5% after accounting for its fees. This means that, net of fees, the active fund underperformed the passive benchmark by 0.5%. Sarah would have earned $500 less with the active fund compared to the passive ETF, highlighting the significant impact of fees on potential outperformance. This example also underscores the importance of Diversification and managing costs in investment strategies.

Practical Applications

The Active Equity Risk Premium is a critical metric for investors and financial professionals in several ways:

• Fund Selection and Evaluation: Investors use AERP to evaluate the historical performance of actively managed funds, determining whether a fund manager has genuinely added value beyond the fund's costs and benchmark returns. Reports like the Morningstar Active/Passive Barometer consistently analyze AERP across various fund categories⁷.
• Asset Allocation Decisions: Understanding the likelihood of achieving a positive AERP informs Asset Allocation strategies. If consistently positive AERPs are rare in certain asset classes, investors may lean towards lower-cost passive alternatives for that portion of their portfolio.
• Due Diligence: Institutional investors and financial advisors conduct extensive due diligence, using AERP calculations to scrutinize the value proposition of active managers. The SPIVA (S&P Indices Versus Active) Scorecard, published by S&P Dow Jones Indices, is another widely referenced report that compares the performance of actively managed funds against their respective S&P benchmarks, showing persistent underperformance for many categories over various time horizons⁶.
• Performance Attribution: AERP analysis is a component of performance attribution, helping to distinguish whether a fund's outperformance (or underperformance) is due to manager skill (stock picking, market timing) or simply market movements (e.g., higher [Beta]).

Limitations and Criticisms

Despite its theoretical appeal, the Active Equity Risk Premium faces significant limitations and criticisms, primarily rooted in the persistent challenge of active management.

• Empirical Underperformance: Extensive research consistently shows that a vast majority of actively managed equity funds fail to outperform their passive benchmarks over prolonged periods, particularly after fees⁵. Data from various sources, including Morningstar and S&P Dow Jones Indices, frequently illustrate this trend. For example, the SPIVA U.S. Scorecard for year-end 2023 showed that a majority of actively managed funds underperformed their assigned benchmarks in most categories⁴.
• Fees and Costs: The higher Expense Ratio and trading costs associated with active management are a major impediment to achieving a positive AERP. These costs eat into any gross outperformance, often turning it into net underperformance³.
• Market Efficiency: The Efficient Market Hypothesis posits that markets quickly incorporate all available information, leaving little room for skilled managers to consistently exploit mispricings for profit². This view suggests that any observed outperformance is often random chance or compensation for taking on additional, uncompensated risk. Critics argue that even metrics like "Active Share," designed to identify genuinely active funds, have not consistently predicted future outperformance¹.
• Survivorship Bias: Performance analyses can be skewed by survivorship bias, where only funds that have performed well continue to exist and are included in studies, while underperforming funds are often merged or liquidated, thus disappearing from the data. This can make the prospects of achieving AERP appear better than they truly are.

Active Equity Risk Premium vs. Market Risk Premium

The Active Equity Risk Premium (AERP) and the Market Risk Premium are both concepts related to expected returns, but they measure different things and serve distinct purposes in finance and Modern Portfolio Theory.

The key difference lies in their reference points and what they seek to explain. The Market Risk Premium is a fundamental input in asset pricing models like the Capital Asset Pricing Model (CAPM), reflecting the broad appeal of equity Equity as an asset class compared to risk-free investments. The AERP, on the other hand, is a narrower concept specifically focused on the efficacy of active strategies within the equity market. It's about whether an active manager can justify their higher fees by consistently outperforming a readily available, low-cost passive alternative.

FAQs

What is the primary goal of active equity management in relation to AERP?

The primary goal of active equity management is to generate a positive Active Equity Risk Premium (AERP). This means the fund manager aims to outperform a chosen benchmark index after deducting all management fees and trading costs, thereby demonstrating their skill in selecting securities or timing markets.

Why is achieving a consistent Active Equity Risk Premium difficult?

Achieving a consistent AERP is difficult primarily due to the efficiency of financial markets and the impact of fees. In efficient markets, all available information is quickly reflected in asset prices, making it challenging for any individual manager to consistently identify undervalued assets or predict market movements. Furthermore, the higher operating costs of active funds, such as management fees and trading expenses, often erode any gross outperformance, leading to net underperformance compared to lower-cost passive index funds.

Does the Active Equity Risk Premium account for investment fees?

Yes, the Active Equity Risk Premium explicitly accounts for investment fees. It is calculated as the active portfolio's return minus the benchmark's return, minus the active management fees. This net-of-fee calculation is crucial because fees significantly impact an active fund's ability to deliver actual value to investors.

How does the AERP relate to diversification?

While not directly a measure of Diversification, the concept of AERP indirectly relates to it. Active managers often deviate significantly from their benchmarks, taking concentrated positions to generate a positive AERP. However, this increased concentration can sometimes reduce diversification, potentially exposing the portfolio to higher idiosyncratic risks if those concentrated bets do not pan out as expected. Investors seeking broader market exposure and lower risk often favor diversified passive strategies over active funds struggling to achieve AERP.