March 10, 2017
by Ryan J. Lehman
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Last year was a particularly difficult period for active mutual fund managers. In particular, two of the broadest categories within the industry – U.S. large-cap blend and intermediate-term fixed income (i.e. core fixed income) – saw the majority of managers underperforming their benchmarks.
In the case of the large-cap blend universe, 82% of managers underperformed the S&P 500 index. Similarly 72% of core fixed income managers lagged the Barclays Aggregate Bond Index. Late last year we addressed this in a research note1 to our clients, offering a number of potential explanations. In a recent white paper, our colleagues at GMO very appropriately asked, “Is Skill Dead?” In this paper they examined the results of the large-cap blend peer group, and offered an optimistic outlook for active managers despite recent underperformance. In this article, I expand upon their work and our own by discussing how managers “cheat” for alpha by taking positions in out-of-benchmark risk premia and beta exposures, and how those bets have compromised recent results.
Before addressing the aforementioned risk premia and betas, it is worth discussing my expectations for the average active manager. As Fama and French stated in “Luck versus Skill in the Cross Section of Mutual Fund Returns,” investing is a zero-sum game gross of fees and a negative-sum game net of fees. Put more simply, for every investor (or in this case for every mutual fund) that produces a positive excess return there is another that produces a negative excess return, netting the average level of excess performance to zero (i.e., total average returns should be equal to the index return). However, when I factor fees into the equation, the average manager is no longer expected to perform in line with the index; rather, they are expected to produce the index return minus fees.
Why then are we surprised that the average large-cap blend and core fixed income managers underperformed last year?
We are not. Instead we are concerned by the degree of that underperformance and, more importantly, by the general lack of understanding of that underperformance by many investors.
Beginning with the large-cap blend universe, the average manager underperformed the S&P 500 by 275 basis points in 2014 (10.94% vs. 13.69%). In theory, this level of underperformance should have been approximately 97 basis points, the index return minus the average manager’s expense ratio, which equates to a return of 12.72%. Within the fixed-income category I found similar results, although not as extreme, where the average active manager underperformed the Barclays Aggregate Bond Index by 83 basis points (5.14% vs. 5.97%). This contrasted with an expectation of 5.27%, given an average expense ratio of 70 basis points.
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