Swedroe: Perspective Matters With Active Mgmt

A UBS white paper argues that active has outperformed, but the original data shows it hasn’t.

Larry Swedroe
Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

In my role as director of research for Buckingham Strategic Wealth and The BAM Alliance, I was asked to comment on a June 2017 white paper, “Active vs Passive: What is the Future of Active Management? (part 2 of 2),” published by the global research team at UBS, one of the world’s largest asset managers.

The focus of the article is the claim that “the latest academic research highlights that active institutional fund managers outperformed [on a strategy-level basis] by 86 bps pa in the United States and by 165 bps pa globally before fees between 2000 and 2012 (fees averaged 49 bps and 58 bps respectively).”

Original Data
The data is based upon the November 2016 study “Asset Managers: Institutional Performance and Smart Betas” by Joseph Gerakos, Juhani Linnainmaa and Adair Morse. To see if the UBS claim is supported, we’ll review their study. Gerakos, Linnainmaa and Morse studied the performance of delegated institutional asset managers with $18 trillion of annual average assets under management over the period 2000 through 2012—close to 30% of worldwide investable assets.

As I’ve previously discussed, their survivorship-bias-free dataset included 22,289 asset manager funds marketed by 3,272 asset manager firms and four asset classes: U.S. fixed income (21% of delegated institutional assets), global fixed income (27%), U.S. public equity (21%) and global public equities (31%). Following is a summary of the authors’ findings:

  • Institutional asset managers charged the average delegated dollar a fee of 44 basis points, about half that of the typical retail mutual fund, providing institutions with an advantage over retail fund investors. The value-weighted mean fee is lowest for U.S. fixed income (29 basis points), followed by global fixed income (32 basis points), global public equity (48 basis points) and U.S. public equity (49 basis points). The equal-weighted fee was 56 basis points—smaller investors pay larger fees.
  • The average asset manager fund earned annual strategy level (where returns are compared to appropriate index benchmarks) gross alpha of 86 basis points, with a t-stat of 3.35 (significant at the 1% confidence level). The net alpha was 42 basis points, with a t-stat of 1.63 (insignificant at the 5% level).

So far so good, it seems, although the net alphas were not statistically significant. The claim of outperformance of 86 basis points gross is backed up by the paper UBS cited, and is based on a strategy-level analysis.

It’s even worth pointing out that the UBS paper did not cite the finding that delegated institutional assets on a market-adjusted basis earned a gross alpha of 131 basis points annually, with a t-stat of 3.21, and a net alpha of 88 basis points, with a t-stat of 2.14.

Citing that statistic would be inappropriate because institutional asset managers could have outperformed simply by taking more risk than the market. Market outperformance was based on the single-factor CAPM model, while the strategy-level outperformance was based on comparing returns to the most similar index benchmarks.

It’s important to note that the CAPM has not been the workhorse asset pricing model since it was replaced by the Fama-French three-factor model (adding size and value to market beta) about 25 years ago.


Better Comparison

To perform a more appropriate risk-adjusted comparison, Gerakos, Linnainmaa and Morse examined how the asset managers achieved that single-factor, and strategy-level, alpha. The authors found that once exposure to the Fama-French factors was accounted for, the alphas disappeared, and there was no risk-adjusted outperformance. In fact, the positive alpha turned negative.

They write: “The [gross] excess return estimate for all asset classes is -0.27 [percent] with a [t-stat] of -0.77.” The net excess return was -0.71%, with a t-stat of 2.0.

Even worse is that, for U.S. equities, the net excess return was -1.16%, with a t-stat of 2.60 and, for global equities, it was -1.69%, with a t-stat of 2.29. The net alphas were positive for U.S. fixed income (0.17) and global fixed income (0.58), although statistically insignificant at even the 10% level in both cases (with t-stats of 0.45 and 0.91, respectively).

With this deeper analysis, we can see that the strategy-level outperformance achieved by the delegated institutional asset wasn’t the result of skill (for which investors should be willing to pay). Instead, it was achieved by systematically overweighting common factors that could have been obtained by the institutional investors themselves through typically lower-cost index funds, ETFs or other passively managed, structured portfolios.

Failure To Outperform

Even with the advantage of asset management consultants (the majority of institutional investors engage consultants such as Russell, SEI and Goldman Sachs) and the added benefit of incurring lower fees than retail investors, institutional investors failed to outperform appropriate risk-adjusted benchmarks.

What’s more, the implementation costs of passive strategies such as index funds, ETFs and other structured portfolios continue to fall, creating even greater hurdles for active management.

One interesting finding is that, because institutions were generating a market-based gross alpha of 131 basis points—given that outperformance is a zero-sum game even before expenses—it must be the case that nondelegated institutional and retail investors were underperforming, even before expenses.

Gerakos, Linnainmaa and Morse estimated that gross underperformance at 53 basis points a year—and that’s even before fees.

In other words, when looked at through the proper lens, active management is a loser’s game, whether you’re an institution delegating management to an active fund manager or an individual playing it.


Exposing False Claims

Investment firms and much of the financial media tout active management because that’s the winning strategy for them, so they write white papers attempting to show the benefit of active management.

An important lesson I hope you’ll take away is that, whenever you hear claims favoring active management, be skeptical. You can virtually be certain they are coming from product purveyors, not from academic researchers. Dig into the data, and you will almost surely find problems.

With that in mind, let’s examine some other assertions made in the UBS paper.

Correlation Direction Is Moot

Among the other issues I found was the claim that, because correlations of stock returns recently have been at high levels, active management’s ability to outperform was diminished. It’s simple to expose this canard, as the research shows that active managers persistently fail, whether correlations are rising or falling.

You see this in the annual SPIVA reports, which S&P Dow Jones Indices has now been producing since 2002, a period that includes rising as well as falling correlations. In addition, as I’ve previously explained, it’s easy to show that rising correlations don’t eliminate the potential for active managers to add value.

Correlation shows the directional movement of stocks, not the magnitude of their movement. Magnitude is shown by the dispersion of returns (the size of differences in the returns of individual stocks/asset classes).

The greater the dispersion, the greater the opportunity active managers have to add value by overweighting the winners and avoiding the losers. Thus, we should look at the dispersion of returns, not the correlations, to see how high of a hurdle active management must overcome. And every year there is a massive dispersion of returns.

For example, in most years, more than half the stocks in the S&P 500 Index finish the year with a return of 10 percentage points more or less than the index itself.


Additional Examples

In 2016, the large majority of active funds underperformed, despite the great opportunity active managers had to generate alpha due to a very large dispersion in returns between the best and worst performers.

For instance, while the S&P 500 Index returned 12.0% for the year, 25 stocks in the index returned at least 45.5%. Among those, Oneok Inc. returned 132.8%, while Nvidia Corp returned 223.9%. “All” an active manager had to do to outperform was to overweight these superperformers.

On the other side of the coin, 25 stocks in the index lost at least 22.9%. Among those, Endo International lost 73.1%, and First Solar lost 51.4%. Again, to outperform, “all” an active manager had to do was to underweight, let alone avoid, these dogs. And 2016 wasn’t unusual. Let’s look at what happened in 2015.

While the S&P 500 Index returned just 1.4% in 2015, 10 stocks in the index returned at least 46.6%, and 25 returned at least 34.2%. On the flip side of the coin, 10 stocks in the index lost at least 55.6%, and 25 stocks lost at least 45.8%. Clearly, there was plenty of opportunity to outperform, and yet the large majority of active funds persistently failed.

Alpha During Downturns
There’s another issue to examine. UBS claimed: “Active managers deliver their alpha during periods of high dispersion of returns. This occurs during market downturns. As a result, active managers protect investors from drawdowns in the market.”

Once again, we find the evidence shows otherwise. For example, a study in the spring/summer 2009 issue of Vanguard Investment Perspectives examined the performance of active funds in bear markets. Defining a bear market as a loss of at least 10%, the study covered the period 1970 through 2008, which included seven bear markets in the U.S. and six in Europe.

After adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.”

It also confirmed that past success in overcoming this hurdle does not ensure future success. The Vanguard study reached this conclusion despite the fact that the data favored active managers because it contained survivorship bias.



In 1998, Charles Ellis published his book, “Winning the Loser’s Game.” He presented evidence demonstrating that, while it was possible to outperform using active strategies, the odds of doing so are so poor that it’s imprudent to try. Just as with other loser games (such as those played in the casinos of Las Vegas), the winning strategy is to not play.

By not playing, Ellis meant using passively managed funds, such as index funds. Unfortunately, for those using active strategies, the odds of winning have been persistently falling since Ellis’ book was published.

In our book, “The Incredible Shrinking Alpha,” my co-author, Andrew Berkin, and I present the evidence demonstrating how much more difficult it has become. For example, 20 years ago, the odds that a mutual fund would generate statistically significant alpha was about 20%. Today that figure is about 2%.

We also present reasons this trend has been so persistent. We then explain why the trend is likely to continue to make life ever-more difficult for those choosing active strategies, while still lining the pockets of the purveyors. But you don’t have to play that game.

Instead, you can play the winner’s game, by first identifying your ability, willingness and need to take risk, then building a globally diversified portfolio with allocations to asset classes and/or factors (or investment styles) you believe are most likely to deliver premiums.

To help you make those decisions, Andrew Berkin and I wrote “Your Complete Guide to Factor-Based Investing.” You can read a review of our recently published book in the June 2017 issue of the Financial Analysts Journal.

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


Larry Swedroe

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.