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 ExodusPoint Partners International Fund returned 0.36% for May, bringing its year-to-date return to 3.31% in a year that's been particularly challenging for most hedge funds, pushing many into the red. Macroeconomic factors continued to weigh on the market, resulting in significant intra-month volatility for May, although risk assets generally ended the month flat. Macro Read More
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 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.”
By Larry Swedroe, read the full article here.