In our www.fundgrades.com data, if we go back over the last six years where this supposedly surging trend of alpha occurred, and look at the total number of funds that fit into one of our thirteen domestic equity categories (also using Thomson data) we find there were 5,745 funds that had at least 70% in equities, and an R-squared relative to at least one of our thirteen domestic equity benchmarks of at least 67.25% (a correlation coefficient of only .82). Only 618 (10.8%) of those funds fell into large blend as their best fits. Small, micro, mid and even total domestic equities would have all outperformed the S&P500 over this recent period…IT MUST BE SKILL!!! Thus, based on a potentially very weak methodology, all Howard’s “alpha trend line” really shows is the S&P500 was a tough benchmark to beat in the 80’s and 90’s (back when his trend line said active managers were stupid and produced negative alpha) and recently became a benchmark just about any indexer of a sub class could beat (or the now brilliant managers that “have become more skilled at creating alpha”).
All of this is caused by comparing his universe of domestic equity funds to a large blend benchmark, and is thus doing nothing other than attributing “alpha skill” to potentially 89.2% of the universe where most of the sub class indexes would have also outperformed his easy benchmark. (The data for just the first three of the six years ending June, 2008, shows a similar relationship with 5,882 funds fitting a domestic equity sub class criteria and only 557 of those fitting into large blend, thus 90.5% of the domestic funds were not large blend. Also, the second three year period of the last six showed 87.0% of the 7,058 funds best fit was something other than large blend. Since we include expenses in our grading routine we do not group share classes of funds and grade each share class individually.)
Ok, so Wermers is somewhat more objective than Howard; and Surz missed a marketing opportunity for the money manager monkeys Surz simulates in his objective PODS universes by reciting the active advocate mantra of the three P’s.
I cannot say that alpha doesn’t exist. It is provable to exist with mere luck as Wermers work and Surz PODS demonstrate. I cannot say that skill doesn’t exist, and statistically one would think someone out there would have it. Intuitively therefore, I assume there is skill.
But, in my clients’ interests I have to objectively assess whether the risk of attempting to identify that skill for potential out performance is worth the risk of underperforming I have the choice to avoid. I also cannot just accept a marketing bromide that sounds good but is not provable. I need to be able to understand how the odds are stacked to know whether making the bet makes sense. Objectively, it is a bet with at least some of the odds being knowable.
For example, there is essentially zero chance that an index fund will even equal the index and, if it is well managed to minimize tracking error, it is nearly certain that it will under perform the benchmark by something close to the expenses. But with this nearly certain small underperformance of the index fund, also comes nearly complete certainty that it will not materially under perform the benchmark. The certainty of the avoidance of the risk of material under performance has value, despite what active advocates might claim. There is value to avoiding that risk.
As a skeptic worried about my clients’ best interests, I need to understand whether the payoff for the bet of potential out performance is worth the risk of potential under performance, AND the odds of either occurring. Knowing the odds is the tough part. If you are objective and thus not either a passive pundit or active advocate, you must acknowledge the facts. Index funds are nearly certain to underperform by their expenses and have essentially no chance of either outperforming or materially underperforming their benchmark. This is fact, not marketing, so all of you active advocates should face it. Also, objectively, one would also have to acknowledge that any active bet introduces a risk of potentially materially underperforming, a risk that one can have nearly complete certainty of avoiding by indexing, yet the active bet also introduces a chance of potential out performance that does not exist with the index fund. Passive pundits, face it!
This is not that complicated if you are objective and filter out the marketing noise and pseudo research of the passive pundits and active advocates. And Wermers’ and Surz’ works go along way toward measuring the luckiness that exists in the historical data; with both (sometimes) objectively acknowledging it isn’t necessarily predictive.
But studies like Howard’s that compare apples to oranges and assume that ANY out performance is automatically skill, that lucky unskilled managers do not exist and that the money management industry was stupid but is now becoming smart do nothing for clients’ interest. But it is good marketing.
While I put no weight on past relative performance, since I have yet to obtain a time machine that would make past performance useful, I couldn’t help but test Howard’s surging alpha “evidence” in our www.fundgrades.com database.
This is not proof of anything; it is just data. However, it is interesting to see how it contrasts with Howard’s “research” on surging alpha skill and declining standard deviation.
