Swedroe: Don’t Blame Lack Of Dispersion

December 14, 2015

In a recent article, Advisor Perspectives editor Robert Huebscher noted: “During the last 40 years, an average of 60% of equity funds underperformed the S&P 500. But, according to the SPIVA data, 86.4% of large-cap managers underperformed their benchmark in 2014. The percentages were not much better last year for mid-cap (66.2%) or small-cap (72.9%).”

The article goes on to cite work by Michael Mauboussin, managing director and head of global financial strategies at Credit Suisse, which makes the case that this poor performance was due to fewer opportunities for active management to add value because the dispersion of returns was lower than historically has been the case.

In other words, “Skill alone is not a predictor of success in active management; a second ingredient—opportunity—must be present. Last year’s failure was not because there were fewer active managers or because they lost their touch.”

While the dispersion of returns last year was indeed lower than the historical average, and you need dispersion to generate alpha, it’s simple to show that there was still plenty of opportunity for active managers to add value. It’s just that they didn’t do it. Even though dispersion may have been less than the historical average, there remained a massive amount of it that active managers could have exploited.

For example, Mauboussin’s data show that the average return of the top half of performers in the S&P 500 in 2014 was 42.9%. Compare that with the average return of the bottom half, which was just 21.3%. That’s a performance gap of 21.6 percentage points. Isn’t that a sufficient opportunity to generate alpha?

A Simple Solution

But it’s even much simpler than that to demonstrate the massive opportunity last year for active managers to add value. Consider the evidence in the table below, which shows the returns for the 10 best and the 10 worst performers in the S&P 500 Index:

10 Best S&P 500 Performers In
10 Worst S&P 500 Performers In 2014 Return
Southwest Airlines 124.6 Transocean Ltd. -62.9
Electronic Arts 104.9 Noble Corp. -55.8
Edwards Lifesciences 93.7 Denbury Resources -50.5
Allergan Inc. 91.4 Ensco PLC -47.6
Avago Technologies 90.2 Avon -45.5
Mallinckrodt PLC 89.5 Genworth Financial -45.3
Delta Air Lines 79.1 Freeport McMoRan Copper & Gold B -38.1
Keurig Green Mountain 75.3 Range Resources -36.6
Royal Caribbean Cruises 73.8 Diamond Offshore Drilling -35.5
Kroger Co. 62.4 Mattel -35.0

All an active manager would have had to do to generate a large amount of alpha was to overweight the top 10 performers and avoid the bottom 10. If they were really good, they should easily be able to avoid the worst 10 performers, shouldn’t they? Isn’t that what investors supposedly are paying them to do? Again, it’s that they just didn’t do it.

Every year, we hear the usual litany of excuses for why active management failed. In recent years, we’ve heard that this occurred because the correlations of returns had risen, reducing opportunities to generate alpha.

Unfortunately, it doesn’t matter what happens to correlations—active managers fail with persistence. Last year correlations fell sharply. Yet despite that, we saw almost 90% of large-cap managers underperform. Falling dispersions is just another excuse that doesn’t hold up to scrutiny.

Actually, there is a very simple explanation for why so large a percentage of large-cap managers underperformed. It’s called the law of style purity, sometimes referred to as Dunn’s law (named after the Southern California attorney who provided the insights).


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