Beating a Dead Horse


Once again, the S&P Indices versus Active Funds (SPIVA®) Scorecard shows the dismal story for active management getting worse and worse. For domestic equity funds in the last 12 months, 86.0% failed to beat their benchmark. The failure rate for five years is a very discouraging 75.3%, yet despite all the evidence to the contrary, advocates for active management continue to ask us to discard our objectivity and engage in the attempt to find market-beating managers. The latest salvo in this never-ending debate comes from Conrad de Aenile of Marketwatch who, after conceding the disastrous results documented in the SPIVA study, nevertheless claims that if you rely on Morningstar ratings for the more remote asset classes such as small cap and international, "you stand a good chance of entrusting your money to people who can beat the markets as well as the odds, in the long run." De Aenile names six examples of funds that have 4 or 5 stars and also received a gold analyst rating from Morningstar.

Naturally, we dug a little deeper into the returns records of these funds by comparing them to the returns of the Morningstar analyst-assigned benchmark. Our goal was to see if alpha had been delivered and if the level and consistency of this alpha was high enough to preclude luck as an explanation (using the statistical t-test at a 95% confidence level). The results were not encouraging. None of the six funds showed a statistically significant positive alpha. Two funds delivered negative alpha of 3% or worse, two funds had positive alpha, but it was so erratic that an additional 160 to 220 years of similar returns would be needed to conclude the presence of skill. The two remaining funds had positive (yet not quite statistically significant) alpha. The charts below show the high volatility of alpha from year to year.







The Figure below shows the formula to calculate the number of years needed for a t-stat of 2. We first determine the excess return over a benchmark (the alpha) then determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager's claim of skill.

It is important to bear in mind that all these funds were chosen with the benefit of hindsight. Picking winners after the race is a great deal easier than picking them before the race. Recently, IFA documented a similar example of a hedge fund manager who picked ten managers in May of 2006 and was certain he would "beat the dickens out of the market." It did not happen. On average, they lost to their benchmarks by the amount of their expenses, which is exactly what we would expect to happen in a highly efficient market.