Active Managers Are Skilled
Stanford Graduate School of Business; National Bureau of Economic Research (NBER)
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University of Pennsylvania – The Wharton School; National Bureau of Economic Research (NBER)
June 9, 2015
Active fund managers are skilled and, on average, have used their skill to generate about $3.2 million per year. Large cross-sectional differences in skill persist for as long as ten years. Investors recognize this skill and reward it by investing more capital in funds managed by better managers. These funds earn higher aggregate fees, and a strong positive correlation exists between current compensation and future performance.
Active Managers Are Skilled – Introduction
There is perhaps no question in money management as controversial as the question of whether active mutual fund managers can outperform monkeys throwing darts. It has been known for a long time that investors are no better off investing with the average active manager rather than just indexing their money. Based on this evidence, many people conclude that active managers lack skill. Yet the amount of money in active management has grown enormously. If, indeed, these managers have no skill, why do investors continue to invest with them?
In an earlier article, “Five Myths of Active Portfolio Management,” we questioned the presumption that the correct measure of managerial skill is the alpha investors earn. There we point out that the alpha investors earn is determined by competition in capital markets and as such, one would expect that all funds, regardless of the skill of their managers, to earn a zero alpha. The intuition is clear. If investors believed that by investing in a particular fund, they can earn a positive alpha, they would want to invest money in that fund. Funds would ow into that fund, and importantly, would only stop owing when the fund’s alpha dropped to zero.
If alpha does not measure managerial skill, then what does? In this article we show that the correct measure of managerial skill is value added: the total amount of dollars the manager extracts from markets. Using this measure we show that the average mutual fund manager has added $3 million per year. Furthermore, we show that value added is highly predictable. Superior managerial performance persists up to 10 years in the future. Perhaps most surprisingly, investors are aware of this skill and reward it by compensating managers accordingly. Consequently, current compensation better predicts future performance than past performance.
The Correct Measure of Managerial Skill
In light of our earlier work, it is tempting to think that the gross alpha (the alpha before fees are collected) measures managerial skill. After all, the gross alpha is the risk adjusted expected return on the underlying portfolio the manager manages. The problem with using this measure is that it ignores the size of the portfolio, and in money management, size matters. Take Peter Lynch, widely regarded as the most skilled active manager of all time. In his first five years managing Fidelity’s Magellan fund, he earned a 2% monthly gross alpha on assets under management of about $40 million. In his last five years, his gross alpha was just 20 basis points (bp) per month on assets that ultimately grew to more than $10 billion. Based on the lack of persistence in gross alpha, one could falsely conclude that most of Lynch’s early performance was due to luck not skill. In fact, the value he added went from less than $1 million/month to more than $20 million/month.
To better understand the problem with using gross alpha, consider the following example. Allison and Bill are both fund managers, although Allison is more skilled than Bill. Assume that despite this skill difference, both charge a fee of 1% and it is optimal for both of them to manage $100 million actively.4 At this size, Allison is able to generate a 2% gross alpha and Bill is able to generate a 1% gross alpha. Given these fees, investors earn a zero net alpha with Bill and a 1% net alpha with Allison. This situation cannot last, investors will want to invest more capital with Allison. They will endow her with an additional $100 million, which she will optimally choose to index. At the new size of $200 million the market will equilibrate (investors will not wish to invest any more money) because she earns a 1% gross alpha (100/200*2% + 100/200*0%) and investors earn a zero net alpha. The important observation is that once the market has equilibrated, Allison and Bill earn the same gross alpha implying that the gross alpha is not informative about their relative skill difference. So where does the skill difference show up? The answer, of course, is in the size of the fund. Allison manages a portfolio that is twice as large as Bill’s. For that reason, she takes home $2 million dollars in compensation, whereas he only takes home $1 million, which correctly reflects their skill difference. In this example, to correctly measure skill, we need to multiply gross alpha by size.
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