Swedroe: Measuring Active’s Underperformance

June 23, 2017

The underperformance of actively managed mutual funds compared to passive investments is well-documented in the literature—as is evidence on the lack of persistence of outperformance beyond just the randomly expected.

For example, in their study “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” published in the October 2010 issue of the Journal of Finance, Eugene Fama and Kenneth French found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill.

Little Evidence Of Positive Returns
A related study by Laurent Barras, Olivier Scaillet and Russ Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” which was published in the January 2010 issue of the Journal of Finance, found only 0.6% of mutual funds have a true positive risk-adjusted net return, while 24.0% have a true negative risk-adjusted net return. And even these very low figures would be lower for taxable investors, as they are all based on pretax returns.

Further evidence is provided by the study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appears in the Summer 2014 issue of The Journal of Portfolio Management. The authors found that it’s actually getting harder to outperform. Specifically:

  • Since 1989, the percentage of managers who evidenced enough skill to basically match their costs (showed no net alpha) has ranged from about 70% to as high as about 90%, and by 2011, was at about 82%.
  • The percentage of unskilled managers has ranged from about 10% to about 20%, and by 2011, was at about 16%.
  • The percentage of skilled managers began the period at about 10%, rose to as high as about 20% in 1993 and by 2011, had fallen to just 1.6%.

Alpha’s Increasing Difficulty
Lubos Pastor, Robert Stambaugh and Lucian Taylor, authors of the April 2015 paper “Scale and Skill in Active Management,” provided insight into why the hurdles to generating alpha are getting higher. The authors, whose study covered the period 1979 to 2011 and more than 3,000 mutual funds, concluded that fund managers have become more skillful over time.

They write: “We find that the average fund’s skill has increased substantially over time, from -5 basis points (bp) per month in 1979 to +13 bp per month in 2011.”

However, they also found that the higher skill level has not been translated into better performance. They reconcile the upward trend in skill with no trend in performance by noting: “Growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack.” These findings are consistent with the other research we have discussed so far.

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