In 1998, Charles Ellis wrote “Winning the Loser’s Game,” in which he presented evidence that while it is possible to generate alpha and win the game of active management, the odds of doing so are so poor that it’s not prudent for investors to try.
At the time, roughly 20% of actively managed mutual funds were generating statistically significant alphas (meaning they were able to outperform appropriate risk-adjusted benchmarks). Today, that figure is much lower.
In our 2015 book, “The Incredible Shrinking Alpha,” my co-author Andrew Berkin and I described several major themes behind this trend toward ever-increasing difficulty in generating alpha:
- Academic research is converting what once was alpha into beta (exposure to factors in which you can systematically invest, such as value, size, momentum and profitability/quality). And investors can access those new betas through low-cost vehicles such as index mutual funds and ETFs.
- The pool of victims that can be exploited is persistently shrinking. Retail investors’ share of the market has fallen from about 90% in 1945 to about 20% today.
- The amount of money chasing alpha has dramatically increased. Twenty years ago, hedge funds managed about $300 billion; today it’s about $3 trillion. And according to the 2018 Investment Company Fact Book, at the end of 2017, there were more than 16,800 funds versus roughly 100 active funds 60 years ago.
- The costs of trading are falling, making it easier to arbitrage away anomalies.
- The absolute level of skill among fund managers has increased.
This last point confuses many investors. They think that if the absolute level of skill in the mutual fund industry has increased, it should be easier to produce alpha.
However, what so many people fail to comprehend is that, in many forms of competition (such as chess, poker or investing), the relative level of skill plays a more important role in determining outcomes than the absolute level of skill.
What’s referred to as the “paradox of skill” means that even as skill level rises overall, luck can become more important in determining outcomes if the level of competition is also rising.
Evidence Of Shrinking Alpha
Despite the claims of active management, the evidence is clear that the hurdles to outperformance are increasing, making it ever-more difficult for active managers to generate risk-adjusted alpha. S&P Dow Jones Indices provides the latest evidence with its analysis of its SPIVA scorecards.
S&P Dow Jones Indices’ Director of Global Research & Design, Berlinda Liu, examined the issue of active managers’ record of persistence over time in a recent article, “Does Performance Persistence of Active Managers Vary Over Time?”
To answer the question posed in the headline, Liu took a step back through time to revisit their historical reports. She found that while for the three years ending in March 2003, 11.4% of all domestic funds managed to remain in the top quartile for three-consecutive years, by March 2016, that figure had fallen to 2.3%. For large-cap funds, it was less than 1%; for midcap funds, it was 0%; and for small-cap funds, it was marginally better, at just under 4%.
She also noted: “The data indicate that persistence scores for March 2018 are significantly lower than those from six months prior for all of the fund categories.” Liu concluded: “A review of the performance persistence figures over time shows a downward trend over the longer-term horizon for equity funds, indicating an increasing difficulty to stay at the top.”
Compounding the problem for active managers is that academic research continues to advance, converting more sources of what were once alpha into beta, making the markets ever-more efficient, increasing the hurdles to active managers. This process is well-described in Andrew Lo’s excellent book, “Adaptive Markets.”
For taxable investors, even that 2.3% figure is too optimistic, because the greatest expense of active managers is typically taxes. Thus, for taxable investors, that figure is likely closer to 1%.
Given all the low-cost, passively managed options available to investors to gain exposure to the factors they want to allocate assets to, the trend toward passive investing seems inevitable. And that will likely only make the competition ever-more difficult, because the dropouts will be less skillful, be they institutional money managers or individuals.
The bottom line is that active management is becoming more and more of a loser’s game.
This commentary originally appeared November 5 on ETF.com
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