BAM Intelligence

Factor ETFs Raise the Active Bar

In our book “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches,” my co-author Andrew Berkin, director of research for Bridgeway Capital Management, and I document the persistent decline of the ability of active managers to generate risk-adjusted alphas.

We show that while 20 years ago about 20% of actively managed funds were generating statistically significant alphas, today that figure is about 2%. As we discuss, one of the four themes behind this trend is that academics have been busy converting what was once alpha (a scarce resource for which active funds can charge high fees (what economists call “economic rent”) into beta (exposure to common factors and thus a “commodity”).

Additionally, providers of products have developed passively managed vehicles (such as index funds and what are often referred to as “smart-beta ETFs”) that allow investors to access these common factors at low cost and in tax-efficient ways. In fact, in terms of total net assets, nonmarket-tracking (factor-based) ETFs have exceeded market-tracking ETFs since 2009.

Increased Competition

These new vehicles have created much greater competition for actively managed funds, whose performance can now be judged not against the market or a single-factor CAPM, but against more appropriate risk-adjusted benchmarks, such as ETFs, that provide exposure to the desired factors.

Earlier research showed that investors rewarded actively managed funds with inflows if they generated alphas against the single-factor CAPM; investors were naive, failing to account for exposure to other factors that are included in now commonly used multifactor models, such as the Fama-French three-factor model (beta, size and value), the Carhart four-factor model (adding momentum) or the Fama-French five-factor model (beta, size, value, investment and profitability).

In other words, if an actively managed fund outperformed the market by having more exposure to value stocks during a period when value stocks outperformed, the fund was rewarded with new cash flows.

This occurred despite the outperformance being explained by exposure to the value factor—not stock selection or market timing skill—and that same exposure could have been obtained more cheaply through a low-cost index fund or ETF. In other words, investors were ignoring the fact that the Fama-French three-factor model had been the workhorse model in finance since 1993, and the Carhart model had superseded it by 2000.

Factor Fund & Investor Behavior

Jie Cao, Jason Hsu, Zhanbing Xiao and Xintong Zhan contribute to the literature with their May 2017 paper “How Do Smart Beta ETFs Affect the Asset Management Industry? Evidence from Mutual Fund Flows.” They examined the impact of factor-based equity ETFs on how investors evaluate mutual fund performance.

Their objective was to determine if the increased availability of factor-based ETFs made investors more sensitive to risk-adjusted alphas and adjusted their fund flows accordingly. Their database covered nearly 4,000 funds and the period 2000 through 2015.

Cao, Hsu, Xiao and Zhan found that, over time, flow sensitivity to the alphas increased significantly after accounting for exposure to the common factors identified in the now-prevalent asset pricing models—over the period, the dominance of the CAPM model over the multifactor models weakens and even disappears.

They also found that this change was more significant for funds with higher exposure to nonmarket risks (such as size, value and momentum) and funds with more sophisticated (institutional) investors, who are more likely to understand sophisticated models as well as risks other than market beta, and thus more likely to use factor-based ETFs as investment tools.

In summary, the authors document that ETFs, which are known for their indexing and tracking attributes, are also impacting investment flows by allowing investors to more properly benchmark the performance of active managers and providing lower-cost and more tax-efficient ways to access common factors.

They concluded: “Investors no longer reward managers for being exposed to common risk factors when ETFs, which could replicate the return to such risk factors, are actively traded.”

Because of the competition from factor-based ETFs, active managers now must demonstrate they can outperform after deducting the influence of easily measurable factor exposures. The findings gain significance when viewed in light of the fact that, according to Morningstar, active funds saw outflows of $285.2 billion in 2016, while passive funds attracted inflows of $428.7 billion.

Conclusions

The bottom line is that investors are becoming more sophisticated in how they evaluate the performance of active managers. That’s good news for investors and bad news for active fund sponsors, including hedge funds, many of which rely on factor-based strategies, but charge much higher fees than their competitor ETFs. This increasing sophistication increases the already-high hurdle for active managers to overcome.

The reason is that it allows investors to differentiate between those active funds that beat the market because of either skill or luck, and those that beat the market simply because they had exposure to common factors, which could be obtained more cheaply. As investors exit funds without sufficient skill to outperform, those funds will be sent to the mutual fund graveyard.

The result will be that the remaining competition will have a higher level of skill, increasing the hurdle for active managers to overcome—there will be fewer suckers at the poker table that can be exploited in the zero-sum game that is the quest for alpha, even before fund expenses, and a negative sum game after expenses.

This persistently increasing level of skill is another of the four themes explored in our book “The Incredible Shrinking Alpha.”

This commentary originally appeared June 5 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE


Larry Swedroe, Director of Research

Director of Research

Larry Swedroe is director of research for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored six more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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