By LARRY SWEDROE
While there’s no longer any debate that active management underperforms in aggregate, the majority of active funds underperform every year, and the percentage that underperform increases with the time horizon studied. If an investor were able to identify the few future alpha generators, active management could be the winning strategy. The logical strategy, as is the case in almost any endeavour, would seem to be to rely on past performance. However, an overwhelming body of academic research demonstrates that the past performance of actively managed mutual funds alone does not provide valuable information as to future performance, and (as the annual SPIVA Persistence Scorecards regularly report) there is less persistence of outperformance than randomly expected. So the quest for a metric that could identify the future alpha generators ex ante continued.
Believers in active management were offered hope with the 2009 study by Martijn Cremers and Antti Petajisto, How Active Is Your Fund Manager: A New Measure That Predicts Performance. They concluded: “Active Share [a measure of how much a fund’s holdings deviate from its benchmark index] predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.” Unfortunately, subsequent research found problems with the conclusions drawn by Cremers and Petajisto:
- Andrea Frazzini, Jacques Friedman and Lukasz Pomorski, authors of the 2016 study Deactivating Active Share, found that controlling for benchmarks, active share had no predictive power for fund returns.
- Ananth Madhavan, Aleksander Sobczyk and Andrew Ang of BlackRock, authors of the 2016 study Estimating Time-Varying Factor Exposures, found that the measure of active share proposed by Cremers and Petajisto was actually negatively correlated (-0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, they concluded that “it is not the case that high conviction managers outperform.”
- In its November 2021 paper, Is Active Share Unattractive?, Morningstar found that since 2011 investors in high-active-share funds in all Morningstar categories had paid higher fees, incurred greater risks, and earned lower returns. While it may have provided a ray of hope at one point, as Andrew Berkin and I demonstrated in our book, The Incredible Shrinking Alpha, the markets have become increasingly efficient over time, raising the hurdles for active management.
- In a related 2022 study, Fund Concentration: A Magnifier of Manager Skill, Chris Tidmore found that alpha had near-zero correlation with concentration in aggregate.
The quest continues
With the evidence against active share mounting, researchers have continued their quest to find a metric that would identify, ex ante, future alpha generators. For example, Martijn Cremers, Jon Fulkerson and Timothy Riley, authors of the 2022 study Active Share and the Predictability of the Performance of Separate Accounts examined if active share combined with past performance was a predictor of mutual fund performance. Unfortunately, they found no statistically significant evidence that the combination could predict the future performance of mutual funds. And while they did find evidence that, using the double sort, they could identify separate account managers who would go on to outperform, that was true only for small stocks, not large stocks, which make up about 90 percent of the market cap.
Another attempt at finding the holy grail metric was made by ZhengAi He and Eric Tan, authors of the 2022 study Shared Experience in Top Management Team and Mutual Fund Performance, in which they examined the role of top management teams (TMTs) in the U.S. mutual fund industry, focusing on the shared experience (overlapping of experience) between fund managers. Their hypothesis was that TMTs illustrate synergy based on shared experience, contributing to information gathering, risk adjustment, decision-making and enhanced productivity. While they did find that high concentration and high active share were characteristics of TMTs, shared experiences did not provide information on the ability to outperform risk-adjusted benchmarks.
In his study Portfolios of Actively Managed Mutual Funds, published in the August 2021 issue of The Financial Review, Tim Riley took a different approach to finding the holy grail of active management. Instead of focusing on individual actively managed funds, he built an optimised portfolio of actively managed funds that had recent strong performance (top 5 percent in the past 12 months) such that the information ratio (a measurement of portfolio returns beyond the returns of a benchmark, usually an index, compared to the volatility of those returns) would be maximised. The good news was that he found that the optimised portfolio did subsequently have low idiosyncratic volatility and statistically significant alphas against asset pricing models. For example, the Carhart four-factor (beta, size, value and momentum) alpha of the optimal portfolio was 2.40 percent per year (t-stat = 2.24) compared to -0.45 percent per year (t-stat = -0.33) for the equal-weighted portfolio. However, the optimised portfolio required high turnover (average monthly turnover of 47 percent), and the alpha only persisted for one quarter—though it was statistically significant only at the one-month horizon. Thus, any alpha would likely be eliminated by transactions costs, let alone taxes (for taxable accounts).
Not surprisingly, Riley also found that investors react to the information with a substantial flow of assets toward funds expected to have short-run outperformance. Those fund inflows could explain the short-term persistence (by creating momentum in performance) and the future lack of performance—increased cash flows increase the hurdles to generating alpha because of diseconomies of scale (increasing market impact costs). This finding is in line with the hypothesis of Jonathan Berk and Richard Green, authors of the 2004 study Mutual Fund Flows and Performance in Rational Markets: “Fund flows rationally respond to past performance in the model even though performance is not persistent and investments with active managers do not outperform passive benchmarks on average.” While Riley’s findings do support Berk and Green’s hypothesis that fund manager skill exists, they don’t provide much hope for investors using active strategies.
Given the potential rewards, and the incentives the active management community has given their higher fees, it is no surprise that the quest for the metric that can provide the holy grail of outperformance continues. With that said, in the face of all the evidence, it is difficult to make the case that active share, active share and past performance, shared experiences or past performance combined with a high information ratio have strong, useful, predictive value in terms of future risk-adjusted outperformance. The evidence demonstrates that investors, especially taxable investors, are best served by identifying the factors to which they want exposure and then selecting the fund(s) that provides them with exposure to those factors in a systematic, transparent, replicable and cost-effective (low cost per unit of exposure) manner.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® and Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-358
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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