The following table shows the four-factor alphas that Bu found over the period 1993 through 2012, as well as the six-factor alphas I found using the tool at Portfolio Visualizer. The purpose of the analysis is to determine whether the four-factor alphas were generated by exposure to the newer factors of quality and low beta.
What we find is that the average alpha of the eight winners fell from 3.3% to 1.0%, and instead of all eight funds showing statistically significant alphas, now just one fund did so. In other words, much of the eight funds’ outperformance is explained by their exposure to the quality and low-beta factors. In the case of the Mairs & Power Growth fund, a 3.5% alpha became a negative 1.5%. In other words, more than 100% of its four-factor alpha was explained by the fund’s 0.62 exposure to the quality factor.
It’s important to understand that this doesn’t take anything away from the performance of that fund. After all, the fund was taking advantage of the quality factor well before academics uncovered and defined it. However, today, there are funds that provide exposure to that factor, such as the iShares Edge MSCI U.S.A. Quality Factor ETF (QUAL).
Bu’s finding that only eight of the thousands of funds that existed at the start of his sample period managed to produce statistically significant alphas is pretty damning evidence against the likelihood of an investor selecting actively managed funds that will outperform.
In addition, while the eight winners averaged a very impressive annual alpha of 3.3%, over the more recent, 15-year period we examined, they provided pretax returns just 0.2 percentage points higher than a low-cost, highly tax-efficient portfolio of indexed ETFs. That is not a lot of pretax alpha given the risks of underperformance—especially because, for the typical actively managed fund, the greatest expense for taxable investors is taxes.
We also saw that the performance of Bu’s eight winners deteriorated dramatically in the post-sample period. All of this evidence provides support for legendary investor Warren Buffett’s advice to investors when choosing between active and passive funds, delivered in Berkshire Hathaway’s 1996 annual report: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.