Swedroe: Active Inefficiency Excuse Hollow

Even many advocates of active management will concede that the efficiency of the market for U.S. large-cap stocks is so great that attempts to add value (generate alpha) through individual stock selection and/or market timing are unlikely to produce positive results.

However, they cling religiously to the notion that active management remains the winning strategy in less informationally efficient markets. And emerging markets are often considered the poster child for an inefficient market.

It’s in light of this stubbornly persistent belief that Umut Gokcen and Atakan Yalcin—authors of the study “The Case Against Active Pension Funds: Evidence from the Turkish Private Pension System,” which appears in the June 2015 issue of Emerging Markets Review—provide evidence in conflict with the idea that active managers are likely to outperform in inefficient markets.

Lessons From The Turkish Market

As of year-end 2012, the Turkish Individual Pension System had roughly $12 billion (in U.S. dollars) in assets under management. The study data, which is free of both reporting and survivorship bias, comes from RASYONET, a private data provider widely used by the financial industry in Turkey. The study covers the period 2004 through 2011 and includes 157 funds. Following is a summary of the authors’ findings:

• Even with the majority of active funds setting their own benchmarks, most don’t fare well when compared against their benchmark returns.
• The average fund underperforms even before fees.
• Not a single category of funds managed to achieve average performance better than its corresponding index.
• Even money market funds could boost returns by cutting down on trading, rolling over repos instead.
• Because the typically used Fama-French size (SMB) and value (HML) factors aren’t available for the Turkish stock market, regression analyses employed the applicable indexes for major asset classes to determine if pension funds were generating alpha (risk-adjusted outperformance). All alphas for equity and bond funds were negative. Money market funds were the sole category t that did generate alpha, and it was very small and not statistically significant.
• Only about 9 percent of the active managers added value over indexing. However, the top-performing funds in one year weren’t able to repeat their success in the following year, making it unrealistic for retail investors to cherry-pick those few successful managers.
• If retail investors put half their money into a fund that follows the government bond index and the other half into a fund that follows the stock market index, they would have done better than investing with the top 10 flexible funds (which we would call tactical asset allocation funds).

It’s Not Just Turkey

The authors concluded: “Our results generally agree with the previous literature” in that most managers “cannot beat the market.” It’s important to note that the authors’ findings are consistent with evidence on the performance of actively managed pension plans in the U.S., other developed markets and other emerging markets.

The authors cited studies on Greek and Polish pension plans, which also found no evidence that pension plan managers were able to generate alpha. In addition, they cited a study on U.K. pension plans, which concluded that pension funds would have been better served with passive indexes.

US Findings
In the U.S., the poor performance of actively managed pension plans is supported by data from a number of studies. For example, a 2008 paper, “The Performance of U.S. Pension Plans,” and a 2005 paper, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” found that:

• Plan sponsors hire investment managers after large positive excess returns earned up to three years prior to hiring.
• Return-chasing behavior doesn’t deliver positive excess returns thereafter.
• If plan sponsors had stayed with the fired investment managers, their returns would have been larger than those actually delivered by the newly hired managers.
• No correlation was found between relative performance in one period and future periods.
• There’s no evidence that the number of managers who beat their benchmarks was greater than would be expected from pure chance.

Vanguard Weighs In
Further evidence that active managers don’t win in inefficient markets comes from a recent study by Vanguard’s research team. The firm’s researchers found that once you account for survivorship bias, 84 percent of U.S. small-cap funds, 73 percent of non-U.S. developed-market funds and 71 percent of emerging market funds underperformed the average return of low-cost index funds in those same categories over the 10 years ended 2013.

While it’s true that those figures are each better than the 85 percent of active U.S. large-cap funds that underperformed over the same period, it doesn’t change the fact that active management clearly was a loser’s game, no matter where you looked.

The data demonstrates that the notion active funds will outperform in so-called inefficient markets is a myth. But you don’t actually need to see the evidence to know active management is the loser’s game in inefficient, as well as efficient, asset classes. All you need is what’s called the “costs matter hypothesis.”

The Costs Matter Hypothesis

William Sharpe demonstrated in his famous 1991 paper, “The Arithmetic of Active Management,” that passive management outperformance doesn’t depend on market efficiency.

Instead, it depends on the simple laws of mathematics, or what John Bogle called the “costs matter hypothesis.” All stocks (be they small-caps or emerging market equities) must be owned by someone. Because passive investors earn the market returns less low costs, and since, in aggregate, active investors must also earn the market return less high costs, passive investors (also in aggregate) must earn higher net returns than active investors.

The bottom line is that active management remains just as much a loser’s game in emerging markets as it is in U.S. large-caps, U.S. small-caps and developed-market asset classes. It’s a game that’s possible to win, but the odds of doing so are so poor that it’s not prudent to try. Just like at the roulette wheel or the craps table, the surest way to win a loser’s game is to not play.

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