You might have thought, intuitively, that the growth of passive investing would make it easier for active managers to generate alpa. But it hasn’t, as new research confirms. LARRY SWEDROE explains why that is.
The U.S. mutual fund industry has experienced a dramatic shift in fund flows from actively managed funds to passively managed funds. Reflecting this change in flows, the market share of passive equity funds increased to more than 50 percent in 2019 — a fourfold increase in share since 1999. In the 2020 edition of The Incredible Shrinking Alpha, Andrew Berkin and I presented both the evidence and the logic supporting the evidence that despite Wall Street claims that active management’s ability to generate alpha would increase as passive investing’s share increased, the reverse has actually been true.
Jeffrey Busse, Kiseo Chung and Badrinath Kottimukkalur contribute to the literature with their April 2021 study, Impediments to Active Stock Selection and the Growth in Passive Fund Management. Their data sample included U.S. mutual funds and spanned the period 1999-2019. They examined the performance of active funds, splitting the period into pre-Great Financial Crisis (1999-2009) and post-GFC (2010-2019). Following is a summary of their findings:
- The growth in passive investments coincides with a substantially more challenging environment for active stock selection, as reflected in a lower fraction of stocks with positive alpha, lower idiosyncratic volatility and higher aggregate liquidity.
- There was a statistically significant positive relation between mean fund alpha and the number of positive alpha stocks during a given quarter (t-stat = 4.74).
- The mean active (passive) fund four-factor (beta, size, value and momentum) alpha was
-0.56 percent (0.26 percent) per year, with mean expense ratio and turnover of 1.17 percent (0.43 percent) and 78 percent (42 percent), respectively. The median active (passive) fund four-factor alpha was -1.03 percent (-0.29 percent) per year, with median expense ratio and turnover of 1.14 percent (0.32 percent) and 60 percent (19 percent), respectively. - As the opportunities to discover alpha decrease, the relation between alpha and fund costs turns significantly negative. To compensate, active managers reduce expenses (though they remain high relative to passive funds) and fund turnover (the mean turnover ratio of active funds declined from around 70 percent at the end of the financial crisis to around 40 percent in 2019).
- A direct implication of the reduction in the payoffs to active management is that the relation between fund costs and performance has shifted strongly negative. The inverse relation between fund costs and performance leads to greater predictability in fund performance, a stronger inverse relation between fund costs and investor flows, and greater sensitivity of investor flows to past performance—suggesting that investors understand that net performance more strongly persists post-GFC.
- The decile of funds with the lowest prior-year expense ratio showed a four-factor alpha that was 1.1 percent greater than the decile of funds with the highest prior-year expense ratio, with results statistically significant at the 1 percent level.
- Fund expense and turnover ratios strongly persist. Thus, performance itself is more predictable during times when the expense ratio and the turnover ratio more strongly relate to fund performance.
- Funds with high active share outperformed only until 2009.
- High-cost funds persistently perform poorly.
Note that the negative alpha is basically explained by the differences in the mean and median expense ratios of the active and passive funds. The above evidence is inconsistent with the theory that an increase in market share of passive funds would make the market less efficient, providing active managers a greater ability to generate alpha. The period since 1999 has seen a dramatic increase in market share of passive funds, yet it has become harder to generate alpha.
In addition, the decrease in the number of stocks generating statistically significant alpha is indicative of increasing, not decreasing, market efficiency— 5 percent fewer stocks showed positive alpha during the later sample period, comprising about 10 percent of positive alpha stocks in the earlier sample period.
Arguments for active fund management rely on the hypothesis that active managers can identify sufficient positive alpha opportunities to justify their incremental costs compared to passive funds.
Their findings led Busse, Chung and Kottimukkalur to conclude: “Since the 2008 financial crisis, alpha opportunities are relatively few. As a result, active mutual funds have been unable to recoup the costs of active management, leading to relatively poor risk-adjusted performance. Compared to their low-cost counterparts, active funds rank low based on alpha and also based on total return. Moreover, with few alpha offsets to their costs, active fund performance is more tightly related to expenses, leading to an increase in performance persistence and a tighter relation between performance and investor flows.”
Important Disclosures: This article is for educational and informational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Information presented herein is based upon third party data and may become outdated or otherwise superseded at any time without notice. Third party 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®. LSR-21-77
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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