By LARRY SWEDROE
Since 2002 S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) Scorecard, which compares the performance of actively managed equity mutual funds to their appropriate index benchmarks. Year after year they show that regardless of the asset class, a large majority of actively managed mutual funds underperform and that there is little to no persistence of outperformance beyond the randomly expected. In addition, studies such as The Selection and Termination of Investment Management Firms by Plan Sponsors have found that while pension plan sponsors hire investment managers after those managers earn large positive excess returns up to three years prior to hiring, post-hiring excess returns are indistinguishable from zero, and if plan sponsors had stayed with the fired investment managers, their returns would have improved.
Despite such findings, institutions delegate tens of trillions of dollars each year to asset managers who primarily follow active strategies. Institutions are generally considered to be sophisticated investors (the majority hire consultants to assist with portfolio construction). If active investing is even approximately a negative sum game (William Sharpe presented the case for this in his 1991 paper, The Arithmetic of Active Management), why do institutions delegate their assets to active managers?
To try to answer that question, Joseph Gerakos, Juhani T. Linnainmaa and Adair Morse, authors of the study Asset Managers: Institutional Performance and Factor Exposures, published in the August 2021 issue of The Journal of Finance, analyzed the performance of delegated institutional asset managers to determine if they had skill (generated gross alpha) and whether or not they added value (generated net alpha). A global consultant provided data covering an annual average of $18 trillion in institutional assets under management over the period 2000 to 2012. The database was free of survivorship bias and backfill bias. The data included quarterly assets and client counts, monthly returns and fee structures for 23,883 strategy-level funds marketed by 3,403 firms. Their analysis focused on four broad asset classes: U.S. fixed income, global fixed income, U.S. public equity and global public equity. Under the assumption that the consultant’s data was representative of institutional delegation in general, the following is a summary of their findings:
- The average delegated institutional dollar paid a fee of 44 basis points. The value-weighted mean fee was lowest for U.S. fixed income (28.7 basis points) followed by global fixed income (31.9 basis points), U.S. public equity (49.2 basis points) and global public equity (58.2).
- The average asset manager has skill sufficient to generate gross alpha, and this skill persists — 45 percent of the funds had negative gross alphas.
- Managers offer fee discounts to compete for institutional capital, thereby sharing the rents that asset managers extract from the rest of the market. At the time of the study, for example, in U.S. equities the typical fee for the first dollar invested was 77 basis points; for a $10 million allocation, it was 68 basis points; and for a $100 million allocation, it was 54 basis points—clients have negotiation power and asset managers, facing competition, cannot keep all the rents by giving take-it-or-leave-it offers.
- Asset managers with large clients display more skill than those with small clients—consistent with large clients facing lower search costs relative to capital.
- The fact that asset managers offer the same fund at different fees implies that not all clients can earn an expected zero net alpha: Even for the same fund, net alpha can be positive for some clients and negative for others.
- Relative to strategy benchmarks, institutions generated gross alphas of 88 basis points with a t-value of 3.35, and net alphas ranged from 32 to 55 basis points depending on client size. However, relative to mimicking portfolios (adjusted for exposure to common factors), there was no outperformance—asset managers provide institutional clients with systematic deviations from benchmarks, providing greater exposure to factors that generate premiums.
- Institutions would be indifferent between delegating and managing assets in house if the cost of managing assets in house were 85.5 basis points. This 85.5 basis points must cover both administrative costs and trading fees. A 2012 study by I. J. Dyck and Lukasz Pomorski found that large pension funds incurred approximately 12 basis points in non-trading costs to administer their portfolios. Thus, trading costs would have to be less than 64 basis points in order to prefer managing assets in house. Given the costs of trading ETFs (expense ratios and trading costs have been falling), the preference is likely to be to move assets in house.
- In the comparison of gross returns, the average dollar invested in asset manager funds outperformed the dollar invested in mutual funds by 49 basis points.
Their findings led the authors to conclude: “Institutional asset managers appear to have skill: value adds are persistent, less than half the funds have negative value adds, and a manager that displays skill in one fund likely displays skill in its other funds in other asset classes.”
They added: “Prices do not appear to be fully efficient, but, rather, appear to exhibit an ‘equilibrium degree of disequilibrium.’ Institutional asset managers, as a group, profit from those informational inefficiencies. However, instead of trading directly on their information with their own capital, asset managers, in effect, sell this information to their clients for a fee. Indeed, we find that asset managers charge higher fees in those market segments that appear to be informationally less efficient. Information acquisition costs, competition among asset managers, and costly search sustain some price efficiencies and result in an industry in which asset managers divide the rents with their clients.”
And finally, they added: “The rise in the ETF market is, however, likely eroding the advantages that asset managers held during our sample period.”
The authors’ findings are consistent with those of Valentin Dimitrov and Prem Jain, authors of the July 2021 study Yes, Virginia, there are Superstar Money Managers in which they examined the sample of money manager recommendations from the annual prestigious Barron’s Roundtable over the period 1968-2019. They found that money managers are skilful — the sample of 3,472 buy recommendations, on average, earned economically meaningful and statistically significant 4.1 percent excess returns over the benchmark S&P 500 Index over the 30 trading days immediately following the meetings. Against the Fama-French five-factor model, the alpha was lower, at 2.8 percent. And beyond the initial 30-day period, there was no reversal in excess returns, and hence the initial reaction could not be attributed to a mechanical reaction to the recommendations.
However, since Barron’s readers learned of the recommendations only after publication, which could be one to four weeks, Barron’s readers were unable to exploit the skills of the superstar stock pickers, as most of the gains (about 90 percent) came before publication (in the first 15 days) — as Roundtable participants trade on the information prior to publication—and transaction costs basically subsumed the remaining gains. Dimitrov and Jain concluded: “Barron’s readers, on average, do not earn excess returns from investing in the recommendations published in Barron’s Roundtable.”
The bottom line is that the evidence supports the hypothesis of Jonathan Berk and Richard Green from their seminal 2004 paper, Mutual Fund Flows and Performance in Rational Markets. They explained: “Investments with active managers do not outperform passive benchmarks because investors competitively supply funds to managers and there are decreasing returns for managers in deploying their superior ability. Managers increase the size of their funds, and their own compensation, to the point at which expected returns to investors are competitive going forward. The failure of managers as a group to outperform passive benchmarks does not imply that they lack skill. Furthermore, the lack of persistence does not imply that differential ability across managers is unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. It merely implies that the provision of capital by investors to the mutual fund industry is competitive.”
They continued: “Performance is not persistent in the model precisely because investors chase performance and make full, rational use of information about funds’ histories in doing so. High performance is rationally interpreted by investors as evidence of the manager’s superior ability. New money flows to the fund to the point at which expected excess returns going forward are competitive. This process necessarily implies that investors cannot expect to make positive excess returns, so superior performance cannot be predictable. The response of fund flows to performance is simply evidence that capital flows to investments in which it is most productive.”
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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