Manager Skill, the Business Cycle, and Fund Returns

It has been suggested that the relationship between skill and returns depends on the phase of the business cycle. The table below confirms this relationship:  

Based on all US equity active open end mutual funds that existed in any month from Jan 1980 through December 2007, resulting in 482,443 fund/month observations. Fund returns are net of automatically deducted fees and are the average of the returns on all share classes that existed that month. Excludes index, allocation, mixed asset, and 529 funds.  Actual alpha reported below is the average monthly return over all funds existing that month minus the S&P 500 return for that month, summed over the 12 months (Jan, Feb,..., Dec) to obtain the annual alpha.

Source: July 2008 Thompson data base

The highest alpha is recorded in recession years (1980, 1981, 1982, 1991, and 2000), with the years on either side (-1 year and +1 year) having the next highest alphas. It is interesting to note that the year before a recession has a positive alpha as compared to the negative alpha for two years prior, which means that an average alpha switch from one year to the next may foreshadow a recession. For example, in 1998 the average fund alpha was -13.1% but swung dramatically upward to 4.7% in 1999. The US experienced a recession in 2000. In the second and third years after a recession the average alpha is slightly negative and becomes more so as the recession recedes further into the past.

Manager skill produces the best returns around and during a recession or, said differently, manager skill is most beneficial during difficult economic times. This is because during such times there is a wide range of possible stock returns, some good and some poor, and so it pays to carefully analyze these possibilities before making an investment decision. During good economic times, on the other hand, the range of possible returns narrows and thus there is less reward for careful analysis. This means that if the economy is healthy, the argument for indexing is more convincing. On the other hand, if economic problems are expected, then active funds represent a superior investment. Since WWII the average business cycle has lasted roughly five years, with one year in recession and four years in expansion. If this is the pattern going forward, then active managers are the better choice. If, however, the business cycle lengthens, the argument in favor of indexing is strengthened. Based on the alphas reported in the table above, the business cycle would have to lengthen to an average of 8 years or longer, with a recession of no longer than 12 months, for indexing to become the superior choice.

The Manager Skill Enigma

I have discussed how the relationship between manager skill and returns is impacted by changing institutional structure and the business cycle. As an asset manager succeeds and grows, it adds institutional constraints that hurt fund performance. These changes include staying in style box, reducing strong portfolio bets, growing larger and older, and switching from sole fund managers to team management. Manager skill produces the best returns during the difficult economic times experienced before, during and after a recession, and produces ever poorer returns as the recession fades into the past. These relationships are not visible in the results of LoF long term studies.  Knowledge of these relationships, however, can help investors and advisors make better decisions with regard to investing in active equity funds and help unravel the manager skill enigma.

References upon request: .

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