Most Popular ArticlesFama-French and the Active-Passive Debate
Dear Editor:
Michael Edesess’ about the latest Fama and French study regarding portfolio manager alpha, calls attention to just another study that misleads financial planners by asking the wrong questions and then presenting the conclusions it draws as “science.” Let’s review some of the problems with this study, and the many other studies like it, that are used to “prove” that active management can’t generate excess returns and that the existence of investment “skill” can’t be proved.
First, Fama and French focus on tracking error, or the returns of a universe of equity mutual fund managers versus the returns of a market benchmark. In their important study on Active Share, Yale professors Cremers and Petajisto introduce a second dimension for measuring returns, which is the amount that each fund’s holdings deviate from the benchmark’s holdings (see my article here). They found that many mutual fund managers are actually closet indexers, and that while small-cap and momentum were important factors in portfolio performance, Active Share, or the deviation of fund holdings from the benchmark, contributed significantly and persistently to fund returns or alpha. Of course the deviation in fund holdings from the benchmark is a direct result of the manager’s skill.
Second, Fama and French err in concluding that small-cap and value stocks on average outperformed during the time period that was studied. In doing so, they fail to point out that focusing on average returns for a time period is a high-risk methodology for determining portfolio construction. For example, when the economy moves from expansion to contraction, investors in small-cap stocks may be bitterly disappointed with the returns of these stocks. In fact, small-caps are often thought of as a “higher beta” investment than large-caps and, depending on valuations, could dramatically underperform large-caps, not to mention bonds and cash.
In addition, investors who own small-cap stocks when they are favored by investors and have high absolute or relative PE ratios will be similarly disappointed. These observations are the common coin of professional money managers everywhere, and they will be happy to sell their small-cap stocks to undereducated financial planners in both circumstances. The average returns of small-cap stocks should be nothing but an interesting data point to investment managers who are trying to best manage portfolio risk.
Finally, and most importantly, the study offers financial planners the false choice of owning equity mutual funds or an equity benchmark, when in fact financial planners have the ability to own other asset classes such as real estate, commodities, bonds, and cash. Unfortunately there are no studies that I’m aware of that evaluate the universe of managers with the flexibility to own all of these asset classes based on their value characteristics, because to my knowledge such a universe of managers does not exist. The closest might be the universe of global-macro hedge funds, although these databases are so corrupted with 2 and 20 fees, leverage, and problems with survivorship bias that I doubt their analysis would yield any useful insights.
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