In our book “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches,” my co-author Andrew Berkin, director of research for Bridgeway Capital Management, and I document the persistent decline of the ability of active managers to generate risk-adjusted alphas.
We show that while 20 years ago about 20% of actively managed funds were generating statistically significant alphas, today that figure is about 2%. As we discuss, one of the four themes behind this trend is that academics have been busy converting what was once alpha (a scarce resource for which active funds can charge high fees (what economists call “economic rent”) into beta (exposure to common factors and thus a “commodity”).
Additionally, providers of products have developed passively managed vehicles (such as index funds and what are often referred to as “smart-beta ETFs”) that allow investors to access these common factors at low cost and in tax-efficient ways. In fact, in terms of total net assets, nonmarket-tracking (factor-based) ETFs have exceeded market-tracking ETFs since 2009.
These new vehicles have created much greater competition for actively managed funds, whose performance can now be judged not against the market or a single-factor CAPM, but against more appropriate risk-adjusted benchmarks, such as ETFs, that provide exposure to the desired factors.
Earlier research showed that investors rewarded actively managed funds with inflows if they generated alphas against the single-factor CAPM; investors were naive, failing to account for exposure to other factors that are included in now commonly used multifactor models, such as the Fama-French three-factor model (beta, size and value), the Carhart four-factor model (adding momentum) or the Fama-French five-factor model (beta, size, value, investment and profitability).
In other words, if an actively managed fund outperformed the market by having more exposure to value stocks during a period when value stocks outperformed, the fund was rewarded with new cash flows.
This occurred despite the outperformance being explained by exposure to the value factor—not stock selection or market timing skill—and that same exposure could have been obtained more cheaply through a low-cost index fund or ETF. In other words, investors were ignoring the fact that the Fama-French three-factor model had been the workhorse model in finance since 1993, and the Carhart model had superseded it by 2000.
Factor Fund & Investor Behavior
Jie Cao, Jason Hsu, Zhanbing Xiao and Xintong Zhan contribute to the literature with their May 2017 paper “How Do Smart Beta ETFs Affect the Asset Management Industry? Evidence from Mutual Fund Flows.” They examined the impact of factor-based equity ETFs on how investors evaluate mutual fund performance.
Their objective was to determine if the increased availability of factor-based ETFs made investors more sensitive to risk-adjusted alphas and adjusted their fund flows accordingly. Their database covered nearly 4,000 funds and the period 2000 through 2015.