The evidence is overwhelming that past performance is a poor predictor of active managers’ performance. That is why the SEC requires that familiar and common disclaimer. Studies have found that, beyond a year or two, there is little evidence of performance persistence. Indeed, the only place performance persists is at the very bottom – poorly performing funds tend to repeat.
Additionally, the persistence of poor performance isn’t generally attributed to poor stock selection. Rather, it is due to high expenses.
A newly published academic study reveals why it’s so hard for active managers to persistently outperform a benchmark. Before discussing that research, let’s review what we already know about the challenges facing active managers.
The literature provides several explanations not only for the lack of persistence in outperformance, but also for why there are far fewer active managers delivering statistically significant alpha today than there were 20 years ago. The portion able to do so has dropped from about 20% to about 2%, and that’s even before considering the impact of taxes. For taxable investors, the largest cost of active management is often taxes, so the 2% figure should probably be cut in half. A 1% chance of success isn’t very good odds, which is why there’s been a persistent trend by both individual and institutional investors away from active toward passive management.
There are many explanations for the difficulty that active managers face in delivering persistent outperformance. Among them is that there are well-documented diseconomies of scale in terms of trading costs (and problems associated with closet indexing for managers who seek to minimize those costs), which undermine even successful active managers as their success brings in new assets. In our book, The Incredible Shrinking Alpha, my co-author, Andrew Berkin, and I provided four other explanations.
First, while markets are not perfectly efficient, as there are many well-known anomalies, they are highly efficient, and the anomalies can be exploited through low-cost, passive strategies that use systematic approaches to capture well-known premiums. Academic research has been converting what once were sources of alpha, which active managers could exploit, into pure commodities, or beta (“loading” on some common factor or characteristic).
For example, active managers used to generate alpha and claim outperformance simply by investing in small, value, momentum or quality stocks. But that is no longer the case today because investors can access these investment factors through passively managed vehicles.
Second, to generate alpha, which even before expenses is a zero-sum game, active managers must have a victim to exploit. And the supply of victims (retail investors) has been shrinking persistently since World War II. Seventy years ago, about 90% of stocks were held directly by individual investors. Today, that figure is less than 20%. In addition, 90% or more of trading is done by institutional investors. Thus, the competition is getting tougher as the supply of sheep that can be regularly sheared shrinks.
Third, the competition is much more highly skilled today. As Charles Ellis explained in a recent issue of the CFA Institute Financial Analysts Journal, “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”
Legendary hedge funds, such as Renaissance Technology and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.
Fourth, there’s been a huge increase in the pool of assets chasing alpha. Consider that just 20 years ago hedge fund assets were in the hundreds of billions. Today, they are about $3 trillion. Thus, you have many more dollars trying to exploit a shrinking pool of alpha at the same time that the competition has gotten much tougher.
This is not prescription for success.
Richard Evans, Javier Gil-Bazo and Marc Lipson, authors of the November 2016 study “Diseconomies of Scope and Mutual Fund Manager Performance,” offer investors yet another possible explanation for this lack of persistence. Their study covered the U.S. mutual fund industry over the period from 1997 through 2015 and about 10,000 funds.
The Peter Principle
Evans, Gil-Bazo and Lipson examined the changes in performance of mutual fund managers that result from alterations in the scope of their duties, defined as an increase in the number of funds under control or an increase in the total size of assets under management following a change in control (a reallocation of funds) that keeps the number of funds constant. First, as we would expect, they confirmed that the scope of manager responsibilities is expanded in response to positive past performance. They found that managers with higher relative four-factor (beta, size, value and momentum) alphas see an expansion in the scope of their responsibilities. They also found that managers with lower relative alphas see a similarly defined contraction in their scope of responsibilities.
However, the authors then demonstrated that instead of such expanding scope leading to superior performance, even after controlling for effects related to fund size, it negatively impacts subsequent performance. Their results were robust to various tests. It serves as another example both of successful active management unable to achieve economies of scale and the Peter Principle (which posits that managers rise to the level of their incompetence) at work.
The authors found symmetry in their results; after a scope reduction, the poor performance of ostensibly worse managers is curtailed, thus providing further support to the scope hypothesis.
The authors concluded: “Our results suggest a significant diseconomy of scope exists with respect to performance similar to the diseconomies of scale previously highlighted and that, together, these two effects may explain the observed attenuation over time in abnormal relative mutual fund returns.”
They added an important point: “One distinction between these explanations is that scope changes impact performance at the individual manager level while scale impacts performance at the fund level.” The authors then observed: “Fund alphas are negatively related to measures of the scope of manager responsibilities: the size of assets managers manage in other funds; the number of other funds managed; and the number of distinct fund investment objectives managed.”
The authors also examined the relative importance of scale and scope. They wrote: “Looking at one standard deviation shifts in scope measures relative to a similar change in fund size, the effect of scope on alpha is roughly half the effect of size.” They also noted that their results were statistically significant.
The findings discussed here demonstrate that scope does not require outside fund flows to respond to abnormal performance. It’s the fund sponsors themselves who can be responsible for the declining performance.
No matter how we look at it, as Jonathan Berk hypothesized in his 2005 paper, “Five Myths of Active Portfolio Management,” successful active management leads to its own demise. Berk’s hypothesis, however, required investors to react to past outperformance with cash flows. Evans, Gil-Bazo and Lipson showed that expanding scope in response to outperformance also attenuates performance.
Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.
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