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BAM Intelligence

It Is Getting More and More Difficult to Generate Alpha, Especially After Taxes

“The Incredible Shrinking Man,” starring Grant Williams, is a 1957 classic American black-and-white science fiction film. As the film’s plot progresses, Williams’ character continues to physically shrink. I think the film is the perfect analogy for what’s happening to the ability of active mutual fund managers to generate alpha today.

Charles Ellis published his wonderful book, “Winning the Loser’s Game,” in 1998. At that time, Ellis provided the evidence demonstrating that, while it is possible to win the game of active management, the odds of doing so are so poor that it isn’t prudent to try. He showed that investors have the greatest likelihood of achieving their financial objectives by investing in passively managed funds (such as index funds) that do not engage in any individual security selection or market timing.

The Incredible Shrinking Alpha

Last year, in “The Incredible Shrinking Alpha,” my co-author, Andrew Berkin, and I presented the evidence demonstrating that, since Ellis wrote his book, there have been four major themes at work which have resulted in a persistent decline in the ability of active mutual fund managers to generate alpha. The four themes are as follows:

  • Academic research has been converting what was once alpha into beta (a common factor easily accessed through low-cost, passively managed funds).
  • The supply of sheep (victims) available to be sheared (exploited) by active mutual fund managers has been persistently shrinking as the percentage of the total market owned directly by individuals (the sheep) has fallen dramatically over the past 70 years.
  • The skill level of the competition engaged in pursuing alpha has greatly increased.
  • The amount of capital chasing this reduced supply of alpha has greatly increased as well.

Now, thanks to a recent study by Jeffrey Ptak, Morningstar’s director of global manager research, we possess further evidence that the likelihood of generating alpha not only has been declining, it’s collapsing. Consider the following.

Robert Arnott, Andrew Berkin and Jia Ye — authors of the study How Well Have Taxable Investors Been Served in the 1980s and 1990s?, published in the Summer 2000 issue of the Journal of Portfolio Management — found that just 22% of funds beat their benchmark on a pre-tax basis. (The average outperformance was 1.4%; the average underperformance was 2.6%.) However, on an after-tax basis, only 14% of funds outperformed. (The average after-tax outperformance was 1.3%; the average after-tax underperformance was 3.2%.)

In his new study, presented in the February/March 2016 issue of Morningstar magazine, Ptak set out to determine how many U.S. equity funds went on to beat their relevant index fund benchmark on an after-tax basis over the 10-year period ending October 2015.

Ptak, who assumes that the investor sells at the end of the period, found that out of the 4,993 funds he studied, only 205 beat their benchmark index fund on an after-tax basis. That’s just 4.1%. On a relative basis, 70% fewer funds outperformed on an after-tax basis than Arnott, Berkin and Ye found to be the case in their study, done just 15 years earlier. And what’s more, 10% fewer did so on an absolute basis.

Ptak also found that it didn’t matter which asset class he looked at; only a very small percentage of active funds outperformed on an after-tax basis. Keep this in mind the next time you hear arguments about active management outperforming in supposedly inefficient asset classes (such as small-cap stocks).

The Bottom Line

Ptak’s study provides powerful new evidence that the ability to generate alpha continues to shrink — while the “emperor” may not yet be completely naked, there are fewer and fewer clothes in his wardrobe.

This commentary originally appeared March 2 on MutualFunds.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.

© 2016, The BAM ALLIANCE

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Chief Research Officer

Larry Swedroe is Chief Research Officer 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 15 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)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

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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