Swedroe: Skill Exists, But Not Enough

There is a large body of evidence demonstrating that active management is a loser’s game, including the 2008 study “The Cost of Active Investing” from Kenneth French, which showed that passively managed funds outperformed actively managed ones, and the 2010 study “Luck Versus Skill in the Cross‐Section of Mutual Fund Returns” from Eugene Fama and French, which showed there was no persistence in the outperformance of active funds beyond the randomly expected.

However, the lack of evidence regarding active managers’ ability to persistently generate alpha does not mean they lack skill. In fact, the evidence, including the 2000 study “Mutual Fund Performance: An Empirical Decomposition into Stock‐Picking Talent, Style, Transactions Costs, and Expenses” from Russ Wermers, shows that active managers generate alpha on a gross-of-fee basis, though subtract value on a net-of-fee basis.

New Evidence

Charles Lee and Christina Zhu contribute to the literature addressing active manager skill with their July 2018 study, “Actively Managed Funds and Earnings News: Evidence from Trade-Level Data.” To shed light on the information processing capabilities of actively managed funds (AMFs), they analyzed trades around earnings announcements (EAs).

A well-known investment anomaly is post-earnings-announcement drift (PEAD), the tendency for a stock’s cumulative abnormal returns to drift in the direction of an earnings surprise for several weeks (or even several months) following an earnings announcement. The explanation for this drift is that investors tend to underreact to recent news, leading to price movement in the direction of the news.

Lee and Zhu noted that prior studies have shown AMF performance is negatively affected by so-called dumb money flows, whereby managers are forced to unwind their positions due to retail investor redemptions. By focusing on AMF trades around EAs, the authors designed their research to reduce the likelihood managers undertook these trades for liquidity-related reasons. Their data sample covers the period 2003 through 2010.

Study Results

Following is a summary of their findings:

• AMFs anticipate earnings news, as average AMF trading volume on the day prior to EAs is 14% higher than the average non-EA period.
• AMFs trade 172% more on EA days than on non-EA days.
• The EA buys made by AMFs are reliably more profitable than their non-EA buys.
• At the fund level, AMFs with higher trading intensity during EAs are also more profitable than AMFs with lower trading intensity during EAs.
• Increased AMF trading during EAs reduces PEAD and leads to faster price adjustment, shifting returns from the post-EA period to the EA period.
• AMF trades earn negative size-adjusted returns when they are not conditioned on EA periods.
• AMFs that focus their trades in EA periods make more profitable trades, both in the EA and non-EA periods. The subset of EA-focused managers has an informational advantage over other AMFs.

By their actions, which reduce the well-documented PEAD anomaly, AMFs not only play an important role in the price discovery process, they work to make the market more efficient. Their findings led Lee and Zhu to conclude: “Collectively, our evidence suggests that AMFs are relatively sophisticated processors of earnings news and that their trading during EAs improves the price discovery process.”

Another finding of note relates to trading in small stocks. Lee and Zhu note: “Our results on the effect of directional AMF trading among small firms suggest that the persistence of the PEAD effect could be due to elevated arbitrage costs, which limit AMF involvement among these stocks.”

This finding is consistent with anomalies persisting well after discovery when limits to arbitrage are present.

Summary

Lee and Zhu provide compelling evidence both that active fund managers possess skill and contribute to the price discovery process, helping to make markets more efficient.

Unfortunately, the authors also found that when trading on non-EA days, the trades AMFs make are not profitable. Importantly, demonstrating that the market is becoming ever more efficient, they also noted the PEAD effect has declined over time, and that in recent years, it is only significant among small firms (where limits to arbitrage exist).

Thus, consistent with evidence my co-author Andrew Berkin and I present in our book, “The Incredible Shrinking Alpha,” this particular source of alpha has been diminishing over time, only increasing the hurdles to generating alpha.

The bottom line for investors is that while active managers possess skill, having skill is only a necessary condition to generate alpha. The sufficient condition is having sufficient skill to overcome all costs, not just trading costs, but a fund’s expense ratio as well. The evidence is clear that, on a net basis, active management remains a loser’s game.

What’s important for you to understand is that, when it comes to investing, the ability to generate alpha is the scarce resource, not your capital. Economic theory tells us it is the scarce resource that earns the “economic rent,” or alpha.

In other words, if there is any alpha on a gross basis, the person with the scarce resource should expect to earn it, not the investor. Furthermore, that is exactly what the evidence on AMFs and hedge funds demonstrates. On a gross basis, they generate alpha, but on a net basis, they subtract value.

This knowledge is important when choosing the winning strategy—which is to avoid the loser’s game of active investing. However, let’s keep this a secret; we don’t want too many to find out—remember, we need the price discovery actions of active managers to keep markets efficient in pricing and allocating capital.

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