A Factor-Based Analysis
Our fifth and final study is “Mutual Fund Performance through a Five-Factor Lens,” an August 2016 research paper by Philipp Meyer-Brauns of Dimensional Fund Advisors. His sample contained 3,870 active funds over the 32-year period 1984 to 2015.
Benchmarking their returns against the newer Fama-French five-factor model (which adds profitability and investment to beta, size and value), he found an average negative monthly alpha of -0.06% (with a t-stat of 2.3). He also found that about 2.4% of the funds had alpha t-stats of 2 or greater, which is slightly fewer than what we would expect by chance (2.9%).
Meyer-Brauns also found that the distribution of actual alpha t-stats had shifted to the left of what would be expected from chance if all managers were able to produce excess returns over the five-factor model sufficient to cover their costs.
He concluded: “There is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.” He added that “funds do about as well as would be expected from extremely lucky funds in a zero-alpha world. This means that ex-ante, investors could not have expected any outperformance from these top performers.”
In 1998, at a time when about 20% of actively managed mutual funds were outperforming their risk-adjusted benchmarks, Charles Ellis called active management a loser’s game. What he meant was that, while it certainly was possible to win the game by selecting funds that would outperform, the odds of doing so were so poor that it wasn’t prudent to try.
Today the combination of academics having converted what once was alpha into beta (a common factor explaining returns)—thus eliminating potential sources of alpha—and that increasingly skilled competition has raised the hurdles, now only about 2% of actively managed mutual funds are generating statistically significant alpha. And that’s even before the impact of taxes on taxable investors.
The choice is yours. You could try to beat overwhelming odds and attempt to find one of the few active mutual funds that will deliver future alpha. Or you could accept market returns by investing passively in the factors to which you desire exposure. The academic research shows that investing in passively managed funds is playing the winner’s game.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.