Swedroe: When Skill Is Factor Exposures

December 18, 2017

Extensive and readily available data show that the persistence of active managers’ outperformance is well below what we would expect from pure chance (randomness).

Making matters worse is that the equity managers who underperform do so by roughly twice as much as the “outperforming” funds beat their chosen benchmarks. Thus, the risk-adjusted odds of outperformance become even more daunting.

Despite the considerable body of evidence, the vast majority of individuals continue to invest in actively managed funds—raising the question of why they do so. One explanation is that at least some of these individuals are unaware of the evidence, and ignorance is expensive.

Scale Vs. Skill

Yang Song contributes to the literature on investor behavior related to actively managed funds with his November 2017 study, “The Mismatch Between Mutual Fund Scale and Skill.” His database included actively managed equity mutual funds from 1984 through 2014 and examined returns in the context of the Fama-French four-factor model.

Song found that in selecting actively managed funds, many mutual fund investors behave as though they rely on the capital asset pricing model (CAPM)—a single-factor model, with its sole factor being market beta—to make decisions. That leads them to confuse the effects of fund exposures to other common factors (specifically, size, value and momentum) with managerial skill.

In a more rational and informed world, mutual fund investors would distinguish return components due to managerial skill from those that are a result of exposure to common factors, which can be obtained far less expensively by investing in lower-cost, passively managed funds. In other words, fund flows are positively correlated with past factor-related returns.

The result is that active mutual funds with positive factor-related past returns accumulate cash flows. In fact, Song found that funds with positive factor-related returns receive twice the flows per quarter, on average, as other funds with the same factor-adjusted returns.

Disappearing Excess Returns

As Jonathan Berk pointed out in his 2005 paper, “Five Myths of Active Portfolio Management,” capital flows into superior performers, which, due to diseconomies of scale (the result of the effects of larger trade sizes on price impacts and on other execution costs), causes future excess returns to disappear.

Consistent with Berk’s hypothesis, Song found that “active mutual funds in the top decile by factor-related average returns over the previous four years, on average, underperform the bottom decile of funds by 450 to 550 basis points (bps) over the subsequent year.”

He also found that, controlling for fund size, “funds with positive prior factor-related average returns have significantly negative future return performance and underperform other funds.”

He concluded: “This behavior is consistent with a market in which active funds with positive prior factor-related returns accumulate so much assets that they subsequently have significantly negative performance through the effect of diminishing returns to scale.”

Song writes: “Negative performance of active funds with positive prior factor-related returns is more significant among those funds that have higher execution and trading costs. This is consistent with the hypothesized scale effect.”

For example, funds with higher turnover rates posted more negative future performance, consistent with fund flows that chase factor-related returns combined with decreasing returns to scale.


The bottom line is that active mutual fund managers have incentives to garner more flows, and thereby collect more fees, by loading on factors other than the aggregate market. Investors who appear to make decisions based on the CAPM increase their flows into such funds. That, in turn, leads to diseconomies of scale and poor future returns. Song added this insight: The incentive to load on common factors that historically have provided premiums is greater for active managers with less skill.

Finally, while investors should not confuse factor loadings with skill, they should consider the fund’s expenses relative to the amount of its factor exposure—a higher expense ratio may be justified because a fund provides sufficiently greater factor exposure to add value beyond the extra expense.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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