the Alpha Myth

Stock Picking Fails in All Types of Markets

the Alpha Myth

A very common sales pitch amongst the active management community is their ability to provide “downside protection” for investors in falling markets. Here is an example from MFS Investment Management and our appropriate response. Given that most investors remember and lived through the Great Recession, this type of language can sound very appealing.

The unfortunate part of the story is that the sales pitch is complete fluff and not backed by any sort of empirical evidence. In fact, the complete opposite has been observed more often than not. In a recent blog post in The Wall Street Journal, Jason Zweig points to analysis conducted by Rui Dai from Wharton Research Data Services. Looking at the University of Chicago’s Center for Research in Security Prices (CRSP) mutual fund database going back to 1962, Mr. Dai found that, “the odds of finding a manager who will preserve your capital in a falling market are ‘slightly worse than the flip of a coin.’”

If we just focused on the last two significant market contractions we can see that Mr. Dai’s comments ring true. During the bear market from 2000 to 2002, the S&P 500 lost -43.4% while the average fund lost -43.2%. The housing crisis from 2007 to 2009, the S&P 500 lost -50.2% while the average U.S. stock fund fell -49.7%.

Mr. Zweig also highlights the market crash of 1973-1974 when index funds were not as pervasive as they are now nor was there nearly the amount of competition in the fund management industry as there is today. During that time, the S&P 500 lost -37.3%, which was the largest market contraction since the Great Depression. How did the average U.S. stock manager do? They lost -38.9%.

These findings are consistent with previous research conducted on this particular topic. In the Fall 2012 edition of the Journal of Investing, a paper entitled Modern Fool’s Gold: Alpha in Recessions attempted to examine active fund performance during economic recessions in the United States. Researchers Shaun Pfeiffer and Harold Evensky examined the fund performance of 1,115 active fund managers for the 20 year period between August 1990 and March 2010. According to the National Bureau of Economic Research (NBER) there were 3 economic recessions and 3 economic expansions. Using the CAPM, Fama/French 3-Factor, and Fama/French/Carhart 4-Factor asset pricing models, they examined the performance over the entire period, during recessions, and during expansions.

Active management failed to deliver higher returns across the full time period, recessions, and expansions regardless of the asset pricing model used to examine risk-adjusted performance. On average, active managers displayed a -0.85% alpha across the entire time period, -0.41% alpha during recessions, and -0.81% during expansions.

Further, persistence in outperformance across economic recessions and expansions is weak. According to the study, “there is over 80% turnover in performance rankings across business cycles. In other words, fewer than 20% of the prior business cycle ‘winners’ are shown to repeat prior performance levels in subsequent business cycles.’” This conclusion adds to the mounting evidence that active fund “winners” over any given time period are more likely a result of simple luck versus an actual display of skill.  

While empirical evidence is always important, it wouldn’t be sound unless it was backed by economic theory in order to avoid the many issues associated with data mining. Fortunate for us, these types of results are exactly what we would expect in a well-functioning capital market.

The arithmetic of active management says that in any type of market environment there is always a winning and losing side to every trade. During market booms, the winning active managers do so to the detriment of the losing active managers. This simple arithmetic is still true during market contractions. For an active manager who is looking to sell in order to protect there must be an active manager who is seeking opportunity and looking to buy. Active management, as a whole, will always lose to passive management net of fees at any point during a business cycle. Only a subset of active managers can outperform the market and passive investors as a whole. Based on the academic research, there is very little persistence in a manager’s ability to consistently come out on top further highlighting the role of luck in picking the heroes and the forgotten of the fund management industry.

It is safe to say that the active advantage during recessions can finally be put alongside the stories of the “Loch Ness Monster” and “Big Foot” in the category of pure fiction.