Why Achieving Alpha For Managers Is a Black Swan
Every quarter or so, the more senior monkeys and perhaps for the younger ones their parents, receive a 401k statement in the mail. Contained within these few pages are the cold hard facts, the summary performances of their retirement nest egg. As they look at the bold red numbers on the front page, some will simply ignore them while others may go into a rage over a few thousand dollar loss. Black or red, I would bet that most investors, not just in 401k’s, have at least wondered why their fee-based active fund managers typically deliver no better results than the market. What they don’t put in “the fine print” is that only less than one percent of managers actually achieve alpha and here’s why…
Charles D. Ellis CFA and Chairman of the Whitehead Institute offers some hard data on the matter. He recently published an article in the Financial Analysts Journal titled, Murder on the Orient Express: The Mystery of Underperformance. As a summary he basically finds that,
…active management may be the only service ever offered that costs more than the value delivered.”This makes sense since the commodity fees charged for index funds means that managers only provide added value when they beat their benchmark. In economic terms, the marginal cost of investing in the fund would equal the excess return minus the incremental fee charged, or alpha. However, the evidence finds that this is in fact not reality.
• Pick any 12-month random period and about 60% of mangers underperform
• Move it to a 10-year time frame and the underperformance grows by 10%
• Double that and it becomes less robust, growing to about 80% of managers
Furthermore, 24% of managers carry a negative alpha and 75% roughly match the market’s return. That leaves about 1% left, similar in probability to Nassim N. Taleb's black swan event. The key difference is that black swans are statistically significant from zero while managers that achieve alpha are not.
Can you name ANY manager who have defied the statistics and achieved alpha?
Buried within Ellis’s article he uncovers a paradox. Despite a fund managers skillfulness, experience, and intelligence the professionals that collectively dominate the buy-side by their very nature disadvantages them to beat their benchmarks. He suports this by saying...
No manager talks candidly to their clients about the difficulty of investment management as firm information and rigorous analyses has proliferated, competitors multiplied, and information advantages have become increasingly commoditized.”
He goes on to point out their two major inherent flaws:
1. They believe deeply in the value of their work, known as familiarity bias. He cites strong circumstantial evidence showing in their literature that benchmarks and historical performance are cherry-picked and that the results are shown without fees.
2. Investment philosophies tend to be oversimplified and sold as a universal truth or a conceptual competitive advantage.
Do you agree with this paradox and are managers somewhat at fault?
In my opinion, I’m going to take Mr. Ellis for his word. Since I can’t see his research, have similar experiences, or proper credentials. I can neither prove nor disprove his findings but I will say that due to his publication it's probable that his analysis is correct. With that said, I’d like to turn to the more senior monkeys who may be fund managers themselves and their professional opinions on the matter.
Do you think achieving alpha is even possible today given the algorithmic programs, HFT, and overall market efficiency?
This is correct. You can read this as well: http://www.economist.com/node/21562928
90% AM PM are actually being paid a shit lot of money (and all their assistant, back/mid and research as well) but they miserably fail to deliver any value. ETF are so much cheaper. I can't see any reason why you will put your money in a mutual fund. This is the same for 90% of HF PM. A correction is long overdue.
100% agree - markets are generally efficient so investors need to use innovative strategies with less competition and more edge.
Suppose a tweed-clad humanities academic says something like “Clearly the presentation of the self in post-colonial feminist societies has been influenced by Noam Chomsky calls ‘the heteronormative displacement paradigm,’ where blah blah blah….” Most folks would just roll their eyes and move on.
Put a brooks brothers-clad ER analyst in front of them saying “Given our model’s projections of sales for product X and GDP growth in country Y, as well as well as the company’s strong financials (detailed in Appendix C), we think Stock Z should be priced at $126 and therefore is a strong buy…” And people lap it up and open their wallets. But this is essentially the same thing as above, finance just has better window dressing and the illusion of solid math to back up their assertions.
There are some anomalies in terms of individual managers who appear to have alpha over very long time horizons.
There are likely many other examples at smaller funds, but it can be a lot of work to identify them.
The reality is that there is no incentive to "beat the market" for most mutual funds because the fee structure rewards asset gathering over performance. The other day my dad said to me (finance lay man) that if he were to hand his money over to anyone it would be Fidelity. Why? Well the reality is that Fidelity have the budget to market themselves as a successful company and retail investors buy into that even though most Fido mutual funds underperform their benchmarks. Also, don't underestimate the Financial Advisor distribution channel that makes it very difficult for average joe to get impartial advice on asset managers.
Secondly, if you are a manager managing a fund, why take the risk of underperforming your peers? As long as you go with the flow and perform in line with everyone else you will keep your cushy 7 figure job. No point in trying to outperform if it means you lag for a few quarters and lose AUM which will kill your salary. This creates a conflict of interest. Jeremy Grantham (value investor) at GMO wrote a great paper on this dilemma.
Finally, the gate keepers for institutional money, investment consltants and trustees, have become obsessed with short-term performance which forces managers to try and deliver excess returns quarter by quarter for fear of losing big mandates. A lot of clients say they believe in long-term investing but get antsy when a manager underperforms for a few quarters.
Unsurprisingly, the investors of Graham and Doddsville, who shun AUM growth for growth's sake and invest for the long-term have bucked the trend and are generally amongst the few managers who consistently beat the market.
I didn't read the comments before posting... but yeah. This. This x 1000. Asset accumulation always leads to irrational position sizing and taking on too many positions. The more you own the more you become the market. Concentration is how you get your alpha. Of course, it's also how you fail miserably. Just don't do the latter.
I agree, even as a relative amateur. I am always disappointed when I see a manager allocating at most 2% of his capital to a given position. If you're investing intelligently, you should feel comfortable putting 10% or more in a single high conviction position. And again, if you are smart about it, you have downside protection: is that company you bought 10% above liquidation value really likely to fall 50%?
Also absolutely agree about asset accumulation. From the HF guys I know, it sounds like even at $500m you start having trouble buying some of the more thinly traded small caps.
I think this really depends on the market. I would agree that it is very difficult in the US or United Kingdom, but I would venture that in emerging markets, where risks aren't as well understood and securities are under-researched, asset managers are more likely to generate alpha vs. the general market index.
My former fund has a 30 year annualized that's 6% higher than the S&P. My current has an 8 year that's even higher. I think this happens with statistically significant regularity.
investment management in aggregate creates no economic value. it just appropriates a slice of capital for the managers. No matter of investment philosophising changes this fact. It's the nature of inter-mediating the investment process.
therefore the strategic issue for an individual asset manager is whether they appropriate their share from other asset managers, from their own clients or a combination of both. I think this needs to be a conscious decision and strategies for investment, fund raising and business organisation should be set in a manner consistent with this decision.
Perspiciatis provident aliquid veniam explicabo aperiam nesciunt dolorem. Et est tenetur reiciendis. Cupiditate iusto doloremque et.
Et enim quasi vitae eaque non. Animi eos qui repudiandae nobis mollitia necessitatibus et. Et sit eum et soluta aut similique.
Sapiente qui et mollitia deserunt. Soluta explicabo quia ut animi. Facere et ut non in illum. Debitis ad ut vero eum officia autem sapiente est. Quia ullam dicta illum nulla beatae. Illo expedita corporis enim ut cumque omnis error. Qui repudiandae dolore delectus perferendis enim reiciendis ipsum delectus.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...