The Never-Ending Pursuit of Manager Alpha – Updated


As we have pointed out on many occasions, that both stock picking and hiring an active manager to pick stocks on your behalf are not the best ideas. While some investors diligently study individual stocks and other investors handsomely pay active managers to deliver alpha (an additional return above and beyond what can be explained by exposure to risk), very few, if any, investors receive alpha on a consistent basis. Considering that the amount of alpha in the world that is available for capture is zero before costs and negative after costs, it is not difficult to understand why this is the case. The dearth of alpha is borne out by numerous academic studies by luminaries such as Eugene Fama and Ken French. Nevertheless, hope springs eternal as evidenced by the nearly 7,000 actively managed mutual funds in existence today.

In order to determine whether or not a fund manager has reliably delivered alpha, a multivariable regression analysis of historical returns can be conducted. This analysis reveals the extent to which the returns could have been replicated with a combination of index funds as well as the value added or subtracted by the manager (i.e., alpha). One very important quantity produced in the analysis is the t-statistic of alpha, which provides a measure of the probability that the alpha could have occurred from chance alone. In general, a positive alpha with a t-statistic greater than two indicates a 5% or lower probability that the excess returns are due to luck. IFA recently conducted its own study of over 300 US equity mutual funds with twenty years of returns data. We required that at least 90% of the funds holdings be in US equities and that the prospectus objective concur with the size/value style of the fund’s holdings (to minimize the impact of style drift). The results are shown below:

Out of all the mutual funds analyzed, only two (0.5%) had a t-stat greater than or equal to 2 (signifying skill at a 95% confidence level), but the significance of the alpha disappeared when a second type of test comparing the funds to their Morningstar analyst-assigned benchmarks was performed, showing inconsistency of results. Although investors may be tempted to invest in one of these two funds, IFA cautions that the sheer number of managers virtually guarantees that there will be some who appear to have demonstrated true skill. Unfortunately, the number of such managers is no higher than what we would have if all of them were monkeys throwing darts at the Wall Street Journal. Two studies that elegantly address this point are:

  1. “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas” by Barras, Scaillet, and Wermers which evaluated 2,076 fund managers over 32 years and found that total observed alpha is consistent with the following breakdown of the population: 75.4% of the funds have a true alpha of zero after costs and 24.0% have a true alpha that is negative, which leaves only 0.6% with a true positive alpha, a number that the authors consider to be "statistically indistinguishable from zero".
  2. “Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates” by Fama and French, which evaluated 819 actively managed funds over 22 years and found that 97% could not be expected to beat a risk-appropriate benchmark. Furthermore, there was no reliable way to identify the 3% in advance.

Anyone who is still convinced that reliable alpha can be easily found should carefully examine the chart below which plots the same actively managed funds for both the observed level of the alpha and the variability of the alpha. The two points labeled “A” show the averages of the funds with positive alpha and the funds with negative alpha. The positive alpha funds had an average alpha of 1.81% with a standard deviation of 11.03%. This means that we would need 149 years of returns to conclude the presence of skill at a 95% confidence level.

The myth of persistency in positive alpha was completely debunked in the Standard and Poor’s Persistence Scorecard which showed that the number of managers who remain in the top half or quartile of their peer group is lower than what we would expect from chance alone. The conclusion of all of these studies is inescapable. Investors’ resources are far better spent focusing on the risk factors of market, size, and value. Asset allocation remains by far the most important determinant of future returns. After determining a risk-appropriate asset allocation, the next important task is to control costs. The pursuit of alpha has two essential problems: It is costly, and it may lead to missing out on the return associated with the risk factors of market, size, and value, which are the more reliable sources of returns. When you are ready to abandon the quest for alpha, you may take IFA’s Risk Capacity Survey to determine a portfolio of index funds that is right for you.