Swedroe: When Trading Detracts From Alpha

March 21, 2016

As explained in my latest book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, accompanying the rapid growth of the actively managed mutual fund industry, the average performance of mutual funds has been trending downward over the past few decades.

Teodor Dyakov, Hao Jiang and Marno Verbeek—authors of the study “The Trading Performance of Active Mutual Funds,” which appears in the August 2015 issue of The Journal of Financial and Quantitative Analysis—found that, in using the Carhart four-factor model (beta, size, value and momentum), the annualized abnormal return on the aggregate U.S. equity mutual fund portfolio was 1.7% during the period 1981 through 1990, but declined to 0.86% during the period 1991 through 2000, and to -0.75% during the period 2001 through 2010.

Our book provides four explanations for this declining trend: academics have converted alpha into beta, eliminating potential sources of alpha; a reduction in the supply of victims that can be exploited; increased competition from the remaining players; and increased cash inflows competing for the reduced supply of alpha.

Active Funds Lose Before Fees/Costs

Dyakov, Jiang and Verbeek contribute to the literature by establishing a striking new fact: Even before any fees and trading costs, active mutual funds tend to lose money through their trading. They explain: “Specifically, the stocks purchased by active mutual funds in the aggregate underperform their benchmark by -0.39% in the subsequent quarter up to a cumulative -0.83% in the subsequent four quarters. Even though the effects are not statistically different from zero, the changes from the previous two decades are.”

They continue: “For example, the reversal in the quarter-ahead performance of aggregate buys amounts to -0.97% and the effect that is statistically different from zero. During the four quarters after they are purchased, the aggregate buys have a cumulative risk-adjusted reversal of performance of -1.26%. The reversals in the performance of the sales are of similar magnitude. In total, the changes in the risk-adjusted performance of the stocks traded by funds across the two periods amount to -1.62% in the first quarter up to a cumulative of -2.51% over the four quarters after portfolio formation.”

The authors noted: “These trading losses stand in stark contrast to the gains from active trading achieved by mutual funds in the earlier period.” For example, during the period from 1980 to 2000, stocks with increases in mutual fund holdings (a relatively higher number of buyers to sellers) outperform those with decreases by 0.9 age points over the next quarter.

They concluded: “This finding suggests that there may be additional forces, other than simply the effect of more money chasing limited alpha, driving the declining mutual fund performance… . This result is the first evidence that the performance associated with stock-picking of fund managers might have decreased with time.”

Why Does Trading Destroy Value?

Dyakov, Jiang and Verbeek also try to answer the question of why mutual funds destroy value with their trading. They do so by measuring the secular trend in the tendency of mutual funds to herd—in other words, the tendency of funds to follow the contemporaneous or past trades of other funds.

The authors found that mutual fund herding has increased over time and that herding is an important driver of funds’ trading losses. They also found that the trading losses of mutual funds tend to be concentrated among stocks with the strongest mutual fund herding.

For example, they found that “stocks in the top quintile with intense buy herding have post-2000 risk-adjusted returns of -2.46% in the following quarter and those with intense sell herding of 0.85%. In the period between 1980 and 2000, these figures are 0.57% and -1.05%, respectively.”

They concluded: “The increased tendency of mutual funds to trade in herds appears to be an important driver of their trading losses.”

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