Fantasy versus Factors

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A casual observer of the investment management industry could easily surmise that active investment managers effortlessly generate “alpha” – risk-adjusted returns in excess of an appropriate market benchmark. After all, year in and year out, advertisements, marketing presentations and sales pitches highlight the “outperformance” of various managers. And year in and year out, many investors chase this “outperformance” to their detriment.

Why is the hunt for alpha such a fruitless quest? The reason is simple - in aggregate, “alpha” does not exist. As Nobel Prize winning economist William Sharpe articulated over two decades ago1, the returns earned by all market participants simply comprise the total market return and hence, one manager’s “outperformance” must be another participant’s “underperformance.” A litany of studies2 has found that active investment managers as a group underperform the market by approximately their costs. Further, manager “outperformance” is not persistent – it’s a coin toss whether today’s “outperforming” manager will be tomorrow’s winner.

Leading financial academics and practitioners have identified strategies that have delivered excess returns that do not rely on the fantastical quest for “alpha”. They have discovered that the stocks of firms that share certain fundamental characteristics called “factors” have expected returns that vary from the overall market. For instance, measured over long periods of time, stocks of small companies have earned higher average returns than stocks of large companies. Value stocks – those low-priced in relation to earnings, dividends, cash flow or book value – have exhibited higher average returns than growth stocks which are often richly priced in relation to these fundamentals. Stocks also exhibit a “momentum” factor: stocks that have done relatively well over the past three to 12 months tend to continue to do so while stocks that have done relatively poorly tend to continue underperforming.

Over the past several years, academic research3 has identified another factor that explains the difference in average returns experienced by stocks. High-quality stocks that exhibit superior profitability have had higher average returns than low-quality stocks. Profits tend to be persistent over time and hence, certain measures of profitability scaled to a company’s assets or book value have been shown to identify stocks of companies that, on average, have higher expected returns.

Factor-based strategies that replicate indices comprised of stocks that share these fundamental characteristics have outperformed the broad market over longer time frames. As evidenced in the following graph, from 1982 through 2012, $1.00 invested in any of the five “factor-based” portfolios – small cap, momentum, value, small cap value (which combines the small company and value factors) or high quality4 – outgrew the overall US market.

Cumulative Gowth of $1.00

1. Sharpe, William F, 1991, “The arithmetic of active management”. Financial Analysts Journal, vol. 47, No. 1, January/February 1991. pp. 7-9.

2. Allen, D., T. Brailsford, R. Bird, and R. Faff. 2003. A review of the research on the past performance of managed funds. ASIC REP 22, Australian Securities and Investment Commission.

3. Fama, Eugene F. and French, Kenneth R., “Profitablity, investment and average returns”. Journal of Financial Economics 82, No.3 (2006):491-518 and Novy-Marx, Robert, “The other side of value: the gross profitability premium”. Journal of Financial Economics, April 2013,Vol.108,No.1:1-28.

4. Indices used are as follows: Total Market – Wilshire 5000; Small Cap – IA SBBI Small Stock; Value – Russell 3000 Value; Small Cap Value – Wilshire US Small Value; and High Quality – MSCI USA Quality. The US Momentum portfolio was constructed by averaging the monthly returns of momentum portfolios 8 -10 selected from the 10 portfolios formed on momentum available from Professor Ken French’s website at