He found that in two of the four categories, large-cap value and large-cap growth, not a single fund had an alpha t-stat above 2. For the two other categories, small-cap value and small-cap growth, the percentage of funds with alpha t-stats of 2 or higher, at 1.8% and 1.1%, respectively, was lower than would be expected by chance.
In light of the evidence that fewer active funds deliver statistically significant alphas than would be expected purely by luck, an interesting question to ask is this: How would investors have known ex-ante which of the more than 1,000 active funds they had to choose from at the start of the period Bu examined would be among the eight that would produce statistically significant alphas?
Given that investors cannot spend alpha, only returns, I thought it would be interesting to see how these winners (in hindsight) performed relative to passive strategies that investors could have chosen as an alternative.
Performance Relative To Index Strategies
Using Morningstar’s asset categorization, I use the iShares ETF from the same asset class to compare performance. Morningstar provides returns for the 15-year period ending June 6, 2018, which includes the out-of-sample period post-2012. Thus, the in-sample period, and that bias, accounts for about two-thirds of the full data sample.
Three of the eight funds (or 37.5%) produced lower returns than their iShares ETF competition, one matched its benchmark and one outperformed by just 0.1 percentage point. The eights funds’ once-impressive average alpha of 3.3% dropped to a far less impressive 0.2%. Given that actively managed funds’ greatest expense for taxable investors typically is taxes, it seems likely the pretax alpha would have been notably reduced on an after-tax basis.
There’s another point worth noting. While indexing is a good strategy, there are well-known negatives to pure indexing that result from efforts to eliminate tracking error. In addition, passive funds that aren’t pure index funds can design their construction rules to create larger exposure to factors that have been shown to deliver premiums (such as size and value).
These advantages are why the vehicles my firm recommends when building portfolios, while they are passively managed (no individual stock selection or market timing), are not index funds. Instead, our vehicles of choice are structured portfolios from AQR Capital Management, Bridgeway Capital Management and Dimensional Fund Advisors (DFA). (Full disclosure: my firm, Buckingham Strategic Wealth, recommends AQR, Bridgeway and Dimensional funds when constructing client portfolios.)
The following table shows returns for the comparable domestic iShares ETFs and Dimensional funds for the same 15-year period ending June 6, 2018: