Swedroe: Active Impacts Returns & Volatility

A vast body of research provides powerful evidence of the failure of active management to generate persistent alpha (risk-adjusted outperformance).

For example, since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) Scorecard, which compares the performance of actively managed equity mutual funds to their appropriate index benchmarks.

The evidence contained in its scorecards supports Charles Ellis’ observation that, while it’s possible to win the game of active management, the odds of doing so are so poor that it’s not prudent to try—which is why he called it “the loser’s game.”

Highlighting The Canard

Importantly, the scorecards have highlighted the canard that active management is successful in supposedly inefficient markets like small cap stocks and emerging markets. The body of evidence is why we continue to see a persistent flow of assets away from actively managed funds.

Miles Livingston, Ping Yao and Lei Zhou contribute to the literature with their study “The Volatility of Mutual Fund Performance,” which will appear in a forthcoming edition of the Journal of Economics and Business. Using data from almost 2,100 equity mutual funds covering the 13-year period 1991 through 2012, they examined the impact of expense ratios and turnover on returns as well as on the dispersion of returns.

Following is a summary of their findings:

• Active management magnifies the extremes of performance.
• Mutual funds with more active strategies, high expense ratios or high turnover ratios have markedly higher dispersion of performance compared to mutual funds with low expense or turnover ratios or relatively passive strategies.
• Funds with higher expense ratios and turnover ratio have had greater volatility of performance as well as lower mean performance, a doubly adverse pattern.
• Funds with higher active share (lower R-squared value) have higher performance variability.
• If a fund has good performance in one period, high active management amplifies its good performance. If its performance is poor in the next period, high active management magnifies the poor performance. The result is greater time-series volatility in performance for funds with active management relative to funds with more passive management. Thus, the higher risk-adjusted return variability of actively managed funds suggests that static, one-period or historical average Carhart 4-factor alphas might not capture all risks.
• Performance volatility is highly persistent.

Hope Behind Outperformance

The fact that active funds have higher volatility should not be a surprise, as the only way active funds can overcome their higher expense and turnover ratios is to concentrate their holdings and hope they outperform.

Higher concentration means they are less diversified. Thus, we should expect higher volatility relative to funds with similar exposure to the factors that have been found to explain the variation of returns (such as beta, size, value, momentum and profitability/quality).

Other Interesting Findings

The first interesting finding was that the expense and turnover ratios of high-performing funds are insignificantly different from zero. On the other hand, Livingston, Yao and Zhou found, for poorly performing funds, higher expense and turnover ratios have a “pronounced negative impact on performance.”

The authors then noted: “Since investors do not know in advance which funds will be good performers and which will be poor performers, higher expense ratios and higher turnover ratios increase downside risk without any upside gain.” They concluded: “This finding provides further justification for not investing in high expense funds.”

A second interesting finding was that “Larger mutual funds are less actively managed and, likely as a result, charge lower expense ratios and trade less,” the authors wrote.

Closet Indexing

While lower expense ratios and lower turnover have positive impacts, the lower active share is a sign of closet indexing, which raises the hurdle for generating alpha, as the higher expenses of active management are spread out over a smaller portion of the portfolio.

This is why, unless a successful active fund ceases to take new assets, successful active management contains the seeds of its own destruction.

The third interesting finding relates to the research on active share. In their 2009 paper “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Martin Cremers and Antti Petajisto found that active share was positively related to future performance.

However, future research has refuted their findings. For example, in May 2012, Vanguard’s research team examined active share as a predictor. Its study covered the 1,461 funds available at the beginning of 2001. Vanguard’s final fund sample comprised 903 funds. Because the study only covered surviving funds, there’s survivorship bias in the data.

Following is a summary of their conclusions:

• Even with survivorship bias, higher levels of active share didn’t predict outperformance.
• The higher the active share level, the larger the dispersion of excess returns.
• The higher the active share level, the higher the fund costs.

These findings not only refute those of Cremers and Petajisto, they are consistent with those of Livingston, Yao and Zhou, which found that active share increased risks as the dispersions of returns increased.

Vanguard’s findings match those of a study by Andrew Ang, Ananth Madhavan and Aleksander Sobczyk of BlackRock. Their study “Estimating Time-Varying Factor Exposures,” published in the Fourth Quarter 2017 issue of Financial Analysts Journal, provided an out-of-sample test (after 2009) of Cremers and Petajisto’s findings.

They found that the measure of active share proposed by Cremers and Petajisto actually was negatively correlated (-0.75) to fund returns after controlling for factor loadings and other fund characteristics. Thus, they concluded it’s “not the case that high-conviction managers outperform.”

Low Turnover’s Predictive Power … Or Not

Cremers updated his work in his October 2016 study “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity.” He now was recommending that active share needed to be combined with low turnover to have significant predictive power.
The problem with that finding, which I confirmed with him, was that it only held true for the first half of the period (through 2001) he studied. Here’s the table he provided me covering the period 2002 through 2015.

As you can see, the active managers in each quintile of active share had negative alphas.

Livingston, Yao and Zhou also examined this issue. They found that, while higher active share was positively related to the performance of the top performers, it was negatively related to the performance of the worst performers. Thus, active share is not a predictor.

Summary

Their findings led Livingston, Yao and Zhou to conclude that: “Mutual funds with more active management, higher expense ratios and turnover ratios are riskier.” They added: “While the lower mean performance of funds with higher expense ratios is well documented, the greater dispersion of performance has been unnoticed.” Forewarned is forearmed.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.