Swedroe: Scale’s Effect On Active Performance

January 18, 2017

Third, the competition is much more highly skilled today. As Charles Ellis explained in a recent issue of Financial Analysts Journal, “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”

Legendary hedge funds, such as Renaissance Technology and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.

Fourth, there’s been a huge increase in the pool of assets chasing alpha. Consider that, just 20 years ago, hedge fund assets were in the hundreds of billions. Today they are about $3 trillion. Thus, you have many more dollars trying to exploit a shrinking pool of alpha at the same time that the competition has gotten much tougher. Not exactly a likely prescription for success.

Conclusion

The evidence keeps piling up that Ellis was correct when, almost 20 years ago, he labeled active management a loser’s game, noting that while it wasn’t impossible to win that game, the odds of doing so were so poor that it wasn’t prudent to try.

Trends in cash flows indicate that investors, increasingly, are agreeing with him, as there has been a persistent, and perhaps now accelerating, trend from active to passive management. In my view, the persistence of this trend has almost the same odds of continuing as the odds that the sun will rise in the east. Contrary to “conventional wisdom,” that will make it even harder for the remaining active investors to deliver alpha.

The reason is that, as we explain in “The Incredible Shrinking Alpha,” the investors who are abandoning the game of active management are almost certainly the prior losers. That means the remaining competition keeps getting tougher (higher average level of skill) and, thus, harder to exploit.

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

 

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