Fama-French and the Active-Passive Debate
The following is in response to Michael Edesess’ article, Luck versus Skill in Mutual Fund Alpha Estimates, which appeared last week:
The Fama and French Farewell Tour
When taking a tour of the western US, one sees wide-open expanses and beautiful vistas. If asked afterwards, the tourists would say they saw little or no evidence of valuable mineral resources along the way. But in fact, the western US is home to many rich deposits of silver, gold, copper, molybdenum, oil, natural gas, and coal, among others. Of course, to detect such deposits it is necessary to sink test wells and/or conduct seismic tests. Such deposits cannot be detected by simply driving above them, since a thick dirt and rock overburden makes detection very difficult.
Think of Fama and French as driving a tour bus through the active equity mutual fund universe. Like many researchers before them, they focus on life-of-fund alphas as a way to detect superior managers. Their thesis is that if managers are skilled stock pickers, then the average long-term performance of all funds will reflect this skill.
This is like asking the tourists to identify mineral deposits along the route by looking out the windows of the bus. Like identifying concealed mineral deposits, the average life-of-fund alpha methodology must detect manager skill through a thick layer of excess portfolio diversification. Exceptional performance resulting from manager skill is obscured by this diversification overburden.
Focusing on manager decisions
Rather than using long-term performance to detect manager skill, a growing line of research focuses on the specific stock-by-stock decisions made by active equity managers. These studies find compelling evidence of manager stock picking skill, with annual alphas exceeding 10% in some cases. In fact, the most recent manager-decision study (Cohen, Randy, Christopher Polk, and Bernhard Silli, 2009. Best Ideas, Harvard Business School working paper), finds that virtually all active managers are superior stock pickers. Thus manager skill is a ubiquitous feature of active equity funds.
So why the polar opposite results between life-of-fund alpha studies and manger-decision studies? The reason is over-diversification. The manager-decision study results, along with the well-known rapid decline in marginal stock risk reduction, argue for a portfolio of no more than10 to 20 stocks. This is consistent with anecdotal evidence that the personal portfolios of professional managers are invested in no more than 15 stocks.
But the typical active equity fund holds 130 stocks. Roughly speaking, bad idea stocks outnumber good idea stocks by 10 to 1. Why do managers so dramatically over-diversify? Investors, advisors, and the industry force them to do so by paying them based on AUM, asking them to be big, asking them to track an index, requiring them to stay in a style box, and requiring them to conform to legal requirements such as the prudent man rule. All of these constraints force funds to over-diversify and thus wipe out the superior performance flowing from manager skill.
Efficient Markets: the last straw
There are many excess return anomalies, so it is a wonder we continue to take seriously the concept of market efficiency. But passive proponents have one final argument: Yes, they say, there are anomalies, but they must not be real since even professional equity managers cannot earn excess returns. However, the manager-decision study results described above demolish this final market efficiency argument.
You can understand why Fama, who first proposed the concept of informationally efficient markets in the 1960s, is a strong proponent of life-of-fund studies, since they uncover little or no manager skill. But of course we now know that it is not the lack of manager skill but the smothering effect of over-diversification that fails to produce excess returns.
Let managers be active
Don’t get taken for a ride on the Fama and French efficient markets farewell tour bus. Instead, ask managers to avoid over-diversifying and thus free them to pursue their best ideas. You will be pleasantly surprised by the ensuing performance.
C. Thomas Howard, PhD
Professor, Reiman School of Finance, University of Denver
and CEO and Director of Research, AthenaInvest, Inc.
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