Swedroe: Institutional's Tiny Edge

With tens of trillions of dollars under management, the performance of institutional asset managers is of great interest. One reason is that institutional managers have at least some theoretical advantages over retail investors.

For example, they often hire professional consultants to help them perform due diligence in interviewing, screening and ultimately selecting the very best of the best. And you can be sure these consultants have thought of every conceivable screen to identify superior fund managers.

Surely they have considered not only managers’ performance records, but also factors such as their management tenure, depth of staff, performance consistency (to ensure a long-term record isn’t the result of one or two lucky years), performance in bear markets, consistency of strategy implementation, costs, turnover and so on. It’s unlikely that, when evaluating a fund, you or your financial advisor would think of something they hadn’t already considered.

An Asset Manager Study
Joseph Gerakos, Juhani Linnainmaa and Adair Morse contribute to the literature on the performance of institutional asset managers with their November 2016 paper, “Asset Managers: Institutional Performance and Smart Betas.” Their study covered the period 2000 through 2012, on average $18 trillion in annual assets, and 22,289 asset manager funds marketed by 3,272 asset manager firms.

The authors’ analysis focused on four asset classes that represent the lion’s share of global invested capital: U.S. fixed income (21% of delegated institutional assets); global fixed income (27%); U.S. public equity (21%); and global public equities (31%).

Their study is free of survivorship bias. In measuring performance, they used 170 different strategy benchmarks. For example, Australian equities were represented by a benchmark.

Following is a summary of their findings:

• Asset managers charged the average delegated dollar a fee of 0.44%.
• The value-weighted mean fee is lowest for U.S. fixed income (0.29%), followed by global fixed income (0.32%); U.S. public equity (0.49%); and global public equity (0.48%).
• The average asset manager fund earned an annual strategy-level gross (net) alpha of 0.86% (0.42%) basis with a statistically significant t-stat of 3.35 (statistically insignificant t-stat of 1.63). Strategy benchmarks explain about 82% of returns.
• The outperformance (alpha) was achieved by taking risks outside of the benchmarks. Once adjusted for exposure to common investment factors (such as size and value in equities and credit and term in bonds), overall alphas not only disappear, but become negative even on a gross basis. For equities, the net alphas were negative and statistically significant at the 5% level for both U.S. and global equities. Net alphas were slightly positive for both U.S. and global bonds, though statistically insignificant.

Gerakos, Linnainmaa and Morse state: “The fact that asset managers outperform strategy-level benchmarks but earn returns comparable to the fund-level mimicking portfolios implies that asset managers provide institutional clients with profitable systematic deviations from benchmarks.”

In other words, the funds are achieving “alpha” by obtaining more exposure than their benchmarks to factors that have provided above-market returns. The finding means institutional investors likely would have been better served by investing in lower-cost, passively managed mutual funds and ETFs that provided the same exposures to these common factors.

Summary

Given the considerable resources that institutional funds have at their disposal, the evidence demonstrates just how difficult it is for active managers to generate alpha. If institutional capital is unable to persistently generate alpha, what are the odds that you or your advisor can?

This type of evidence is why there is a strong and persistent trend for institutional and retail investors to move assets from active to passive strategies. It also helps explain the tremendous growth in the ETF industry as investors focus on gaining exposure to well-documented factors and accessing them at low costs.

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