the Alpha Myth_w750

When Mythology Is Confused with Reality

the Alpha Myth_w750

In the investment industry, the term “white paper” carries a lot of currency. As for what distinguishes an ordinary article from a full-fledged white paper, it is usually just a matter of length or the number of charts included. It is important to bear in mind that white papers are not necessarily peer-reviewed (that would be the exception rather than the rule), and they are just as likely to contain misinformation as a paper of any other color. In reviewing the latest white paper from RidgeWorth Investments titled “Large Cap Value Indexing Myth-Conceptions”, that is exactly the conclusion we reached.  

As the title suggests, the purpose of this white paper is to convince investors (both individual and institutional) that they need active management, especially in the category of U.S. large cap value. Why they singled out that category from all the others was never made clear, but perhaps it has something to do with the fact that large value underperformed the rest of the market in the past ten years, meaning that any large value manager who style-drifted increased his chance of beating the benchmark.

The white paper presents five so-called myths about indexing that we will examine more closely.

Alleged Myth #1: Active management is not worth the extra cost.

After acknowledging a 0.60% average expense difference between active and passive, RidgeWorth dismisses it and cautions us about the all-important distinction between cost and worth. To buttress their argument, they note that the top quartile of actively managed funds had a 1.0% higher annualized return than the Russell 1000 Value Index for the ten years ending 12/31/2013. As for how you should have picked the top quartile members at the beginning of the period, RidgeWorth has nothing to say of any import. Regarding whether the Russell 1000 Value Index is the best measure of the large value asset class, it is worth noting that the DFA U.S. Large Cap Value Fund, which makes no attempt to identify undervalued or overvalued securities or to time the market, exceeded it by 1.3% for the same time period.

As for whether active management is worth the extra cost, the evidence is overwhelming that it is not. The thirteen landmark academic papers cited by Index Fund Advisors in its Investment Policy Statement argue quite strongly that investors are unlikely to benefit from stock picking, market timing, or manager picking in an efficient market. One such study is “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas” from the Journal of Finance. Using a sample of 2,076 actively managed US equity funds between 1975 and 2006, the authors found that total observed alpha among all the funds 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". The pie chart below summarizes the results:

 

Alleged Myth #2: Active managers do not consistently outperform.

According to the authors of the white paper, “We believe our research demonstrates that while all active managers do not outperform on a relative basis, some consistently do and by a significant amount.” In this case, “some” means 61 out of 253 funds or 24% that outperformed the Russell 1000 Value Index at least 75% of the time across all rolling three-year and five-year periods. However, one problem with this 24% result is that it does not include the impact of survivorship bias. A study done by Dimensional Fund Advisors found the ten-year survivorship rate for domestic equity funds to be 51%. This would bring the 24% down to 12%.  In a similar study over a 15-year period, Vanguard found that 97% of the outperformers had at least five years of outperformance, and 66% had at least three years of consecutive underperformance. The point is that even if a would-be manager picker had been so lucky as to pick an outperformer 15 years ago, he or she would have had a difficult time holding that fund for the entire period.

 

Alleged Myth #3: The selection process for an active manager is not worth the cost.

Just what exactly is this selection process that identifies benchmark-beating managers in advance? No matter how many times you read through this white paper, you simply will not find it because it is not there and for a very good reason—it does not exist. Nevertheless, RidgeWorth explains why we should undertake this effort to find these market-beating managers:

“Indexed products are certainly an easier choice than researching active managers, but the idea of effectively ‘buying the market’ with a passively managed product hinges on being satisfied with market returns. Settling for this this can leave considerable return potential on the table and may also translate into greater market exposure.  Active managers offer the ability to take advantage of stock mispricing opportunities and can take steps that may help protect assets against both individual security and broad market dislocations.”

Once again, we have the canard of active managers performing better in bear markets. This myth was busted by the Standard and Poor’s Index vs. Active Scorecard (SPIVA)1 of 12/31/2011:

“Bear markets should generally favor active managers. Instead of being 100% invested in a market that is turning south, active managers would have the opportunity to move to cash, or seek more defensive positions. Unfortunately, that opportunity does not often translate to reality. In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.”

The table below provides the numbers.

 

As to the question of whether we should be satisfied with market returns, given that they are available for the taking, and the fact that a substantial majority of active managers have failed to outperform them, yes, we can and should be satisfied with market returns.

 

Alleged Myth # 4: The large cap value market does a pretty good job pricing risk.

To this we would say that not only does the large cap value market do a pretty good job pricing risk, so do the large cap growth market, the small cap value market, and all the other equity markets, both domestic and foreign. According to RidgeWorth, while the large cap value market has been efficient over the long term, it has not always been the case in the short term. Thus, it continuously provides opportunities to benefit from undervalued securities via active stock selection. To test this assertion, we decided to take a closer look at the performance of RidgeWorth’s eight actively managed equity funds. The charts below show year-by-year alphas (excess of fund return over benchmark) compared to their Morningstar analyst-assigned benchmarks along with a calculation of t-stats to determine if the average alphas are statistically significant. None of the eight funds had statistically significant alpha, and for the fund with the highest average alpha (RidgeWorth Aggressive Growth Stock), we would need 47 years of similar returns to achieve statistical significance, but we only have 9 years. Only 3 out of the 8 funds had a positive information ratio (defined as average excess return divided by tracking error), and their large cap value fund was not one of them.

 

 

 

 

 

 

 

 

Furthermore, based on Morningstar data, we identified 9 RidgeWorth equity funds that were either liquidated or merged into other funds. Thus, the returns delivered by the 8 funds analyzed above in no way represents the sum total of the investment experience for all RidgeWorth shareholders.

To summarize, if there were indeed continuously appearing opportunities to exploit mispriced stocks, then we should see consistent positive alpha, which is not the case. In our view, the market’s ability to price risk is quite a bit better than “pretty good”, and those who think they can do a better job of pricing risk than the market are likely to have a rude awakening.

 

Alleged Myth #5: With indexing, there is no need to worry about losses incurred by a manager’s wrong choices.

The very nature of indexing entails removing a human manager playing the role of stock picker. For a properly designed index, the risks that investors are exposed to are of a systemic nature and have little to do with picking “wrong” companies. The authors admit that with active management, the possibility of harm resulting from the manager’s poor choices is a real worry, but they instruct us on how to mitigate this risk:

“However, this risk may be managed by identifying portfolio managers who possess clear and consistent stock-picking skills that have delivered market-beating returns time and time again.”

So basically RidgeWorth is telling us that we should look for active managers based on their track records. Unfortunately, both the Standard and Poor’s Persistence Scorecard1 and Vanguard’s Case for Indexing2 both found that for a group of managers that are in the top half or quartile of their peer group in one period, the proportion that stay in the top half or quartile is less than what we would expect from chance, contradicting this assertion. The chart below summarizes the results of the S&P Persistence Scorecard:

While there is no type of investing that is worry-free, utilizing active management compounds both costs and worries that are completely unnecessary to achieving higher returns.

To summarize, all of the “myths” identified in the white paper are either facts or they are based on a false premise.  The one truly mythological creature that the white paper fails to acknowledge as such is none other than the mythical alpha generating manager.

The Alpha Myth Painting

 


1http://us.spindices.com/resource-center/thought-leadership/spiva/

2Philips, Christopher B., and Francis M. Kinniry Jr., 2013. The Case for Index-Fund InvestingValley Forge, PA: The Vanguard Group.