Cao, Hsu, Xiao and Zhan found that, over time, flow sensitivity to the alphas increased significantly after accounting for exposure to the common factors identified in the now-prevalent asset pricing models—over the period, the dominance of the CAPM model over the multifactor models weakens and even disappears.
They also found that this change was more significant for funds with higher exposure to nonmarket risks (such as size, value and momentum) and funds with more sophisticated (institutional) investors, who are more likely to understand sophisticated models as well as risks other than market beta, and thus more likely to use factor-based ETFs as investment tools.
In summary, the authors document that ETFs, which are known for their indexing and tracking attributes, are also impacting investment flows by allowing investors to more properly benchmark the performance of active managers and providing lower-cost and more tax-efficient ways to access common factors.
They concluded: “Investors no longer reward managers for being exposed to common risk factors when ETFs, which could replicate the return to such risk factors, are actively traded.”
Because of the competition from factor-based ETFs, active managers now must demonstrate they can outperform after deducting the influence of easily measurable factor exposures. The findings gain significance when viewed in light of the fact that, according to Morningstar, active funds saw outflows of $285.2 billion in 2016, while passive funds attracted inflows of $428.7 billion.
The bottom line is that investors are becoming more sophisticated in how they evaluate the performance of active managers. That’s good news for investors and bad news for active fund sponsors, including hedge funds, many of which rely on factor-based strategies, but charge much higher fees than their competitor ETFs. This increasing sophistication increases the already-high hurdle for active managers to overcome.
The reason is that it allows investors to differentiate between those active funds that beat the market because of either skill or luck, and those that beat the market simply because they had exposure to common factors, which could be obtained more cheaply. As investors exit funds without sufficient skill to outperform, those funds will be sent to the mutual fund graveyard.
The result will be that the remaining competition will have a higher level of skill, increasing the hurdle for active managers to overcome—there will be fewer suckers at the poker table that can be exploited in the zero-sum game that is the quest for alpha, even before fund expenses, and a negative sum game after expenses.
This persistently increasing level of skill is another of the four themes explored in our book “The Incredible Shrinking Alpha.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.