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).
