The Quest for Alpha

The Holy Grail of Investing

Larry E. Swedroe

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9780470926543
• eBook ISBN: 9781118005705
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Inversiones y valores

The final word on passive vs. active investing

The debate on active investing-stock picking and market timing-versus passive investing-markets are highly efficient and almost impossible to outperform-has raged for decades. Which side is right? In The Quest for Alpha: The Holy Grail of Investing, author Larry E. Swedroe puts an end to the debate, proving once and for all that active investing is likely to prove futile as the associated expenses-costs, fees, and time spent analyzing individual stocks and the overall market-are likely to exceed any benefits gained. The book

• Presents research, data, and quotations that reveal it's extremely difficult to outperform the market
• Explains why investors should focus on asset allocation, fund construction, costs, tax efficiency, and the building of a globally diversified portfolio that minimizes, if not eliminates, the taking of idiosyncratic, uncompensated risks
• Other titles by Swedroe: The Only Guide to Alternative Investments You'll Ever Need and The Only Guide You'll Ever Need for the Right Financial Plan

Investors are on a never-ending search for a money manager who will deliver returns above the appropriate risk-adjusted benchmark, aka the "Holy Grail of Investing." The Quest for Alpha demonstrates that it's a loser's game-while it's possible to win, it's so unlikely that you shouldn't try.

Chapter 1

Mutual Funds: The Evidence

There are many studies on the performance of actively managed equity mutual funds. They provide evidence that is both consistent and overwhelming. For example, a 2002 study by Mark Carhart and three colleagues analyzed the performance of 2,071 equity funds for the period 1962–1995. They found that the average actively managed fund underperformed its appropriate passive benchmark on a pretax basis by about 1.8 percent per annum.1 This study built on the work of an earlier Carhart paper, “On Persistence in Mutual Fund Performance.” Among its conclusions were:

• There was no persistence in performance beyond what would be randomly expected—the past performance of active managers is a poor predictor of their future performance.
• Expenses both reduce returns on a one-for-one basis and explain much of the persistent long-term underperformance of mutual funds.
• Turnover reduces pretax returns by almost 1 percent of the value of the trade.

Carhart’s conclusion: “While the popular press will no doubt continue to glamorize the best-performing mutual-fund managers, the mundane explanations of strategy [asset-class allocation, not individual stock selection] and investment costs account for almost all of the important predictability in mutual fund returns.”2

Keep in mind that Carhart’s findings are all pretax. After taxes, the results would have been worse because of the greater turnover incurred by actively managed funds.

When You Wish upon a Morningstar

One of the most common investment strategies employed by individual investors is to buy the mutual funds that are highly rated by Morningstar. Morningstar itself provided us with evidence on how successful a strategy that is.

The November 2009 issue of Morningstar’s FundInvestor provided the following evidence on its five-star funds:

• The 2004 class of five-star domestic funds had a five-year rating of just 3.2, just slightly above average. And, as we have seen, the average fund has underperformed its risk-adjusted benchmark by close to 2 percent.
• The 2005 group of five-star funds had a three-year rating of just 3.1.
• The 2006 group had a three-year rating of just 2.9.

The paper “Mutual Fund Ratings and Future Performance” from the Vanguard Institute provides further evidence on the ability of star ratings to predict the future.3

Authors Christopher B. Philips and Francis M. Kinniry Jr. examined the excess returns over the three-year period following a given rating. They chose the three-year period because Morningstar requires at least three years of performance data to generate a rating and investment committees typically use a three-year window to evaluate the performance of their portfolio managers. The period covered was June 30, 1992 through August 31, 2009. The following is a summary of their findings:

• Thirty-nine percent of funds with five-star ratings outperformed their style benchmarks for the 36 months following the rating, while 46 percent of one-star funds did so.
• Most of the star-rating groups produced negative excess returns in the succeeding three years. Even worse, the four- and five-star figures were more negative than those of lower-rated groups.

Philips and Kinniry concluded: “Higher ratings in no way ensured that an investor would increase his or her odds of outperforming a style benchmark in subsequent years.”

In fact, they found that “5-star funds showed the lowest probability of maintaining their rating, confirming that sustainable outperformance is difficult. This means that investors who focus on investing only in highly rated funds may find themselves continuously buying and selling funds as ratings change. Such turnover could lead to higher costs and lower returns as investors are continuously chasing yesterday’s winner.”

The bottom line is that using Morningstar’s ratings system is like driving forward while looking through the rearview mirror. The system does a great job of “predicting” the past.

The Vanguard Institute paper also addressed one of the questions I am frequently asked: “If index funds are so good, why do many of them carry three-star (average) ratings?” The authors explain that “the natural distribution of the actively managed fund universe around a benchmark (the index) dictates that an appropriately constructed and managed index fund should fall somewhere near the center of that distribution.” (It is important to note that it will fall to the right of the center of distribution due to lower costs.)

Think of it this way: A sprinter in a 100-yard dash might be able to overcome wearing a two-pound weight on each ankle, but the odds of doing so decrease with the length of the race. And the odds of winning a marathon with that handicap are close to zero. Thus, it is over longer periods that cost advantages of passively managed funds have a greater influence on the distribution of relative performance.

Focus Funds

One often-heard excuse for the failure of the typical mutual fund is they are “overdiversified”—by owning so many stocks, the value of the manager’s best ideas are diluted. Warren Buffett seems to agree with that hypothesis. Here is what he had to say about diversification: “Wide diversification is only required when investors do not understand what they are doing.”4

The mutual fund industry’s solution (or sales pitch) to what Buffett called “di-worse-si-fying” portfolios is to create “focus” funds—funds that concentrate holdings in the manager’s best ideas. While most mutual funds hold well over 100 stocks, the typical focus fund will hold 40 or less. There are even funds that hire several submanagers for just their single best pick.

The question for investors is: does concentration of risk improve returns? Travis Sapp (associate professor of finance, Iowa State University) and Xuemin (Sterling) Yan (associate professor of finance, University of Missouri, Columbia) sought the answer to that question in their 2008 study “Security Concentrations and Active Fund Management: Do Focused Funds Offer Superior Performance?”5 Their database covered the period from 1984 through 2002 and contained 2,278 funds comprising 16,399 fund-years. The study excluded funds with less than 12 holdings, as well as those with less than $1 million in assets. The following summarizes their findings:

• There was no evidence that focus funds outperform diversified funds. In fact, after controlling for other fund characteristics, funds with a large number of holdings significantly outperformed funds with a small number of holdings both before and after expenses—fund performance was positively, not negatively, correlated to the number of securities in the portfolio.
• The quintile of funds with the fewest holdings realized an economically and statistically significant annual three-factor alpha of negative 1.44 percent.
• At the one-year horizon, the buys of focus funds underperformed their sells by 0.3 percent.
• Focus funds have significantly higher return volatility and tracking error to benchmarks. Thus, investors were taking greater risk while earning lower returns.
• Focus funds held considerably larger cash positions: 12.8 percent versus 7.8 percent for diversified funds. Cash acts as a drag on returns for equity funds.
• The attrition rate of focus funds is higher than for diversified funds.

One explanation for the underperformance of focus funds is that the larger the ownership stake in a stock becomes, the greater the trading costs—the fund cannot react quickly to new information without incurring significant trading costs. As the authors noted, “Even if managers of focused funds have better stock-picking ability, their funds might not perform better than diversified funds because of liquidity problems.” Once trading costs are added to the burden of their relatively high operating expense ratios, achieving a positive risk-adjusted alpha becomes difficult. This issue is discussed further in Chapter 7.

Another explanation for the failure of focus funds is that while the market may not be perfectly efficient, it is sufficiently efficient that after expenses it is difficult to exploit any pricing errors.

The evidence on bond mutual funds is just as compelling.

Active Management of Bond Funds

The following are the results of just two of the many studies that could be cited on the attempts of active management to exploit market inefficiencies in the fixed income markets. Christopher R. Blake (professor of finance, Fordham University, Graduate School of Business Administration), Edwin J. Elton (professor of finance, NYU, Stern School of Business,), and Martin J. Gruber’s (professor of finance, NYU, Stern School of Business) 1993 study, “The Performance of Bond Mutual Funds,” covered as many as 361 bond funds and showed that the average actively managed bond fund underperformed its benchmark index by 0.75 percent to 0.95 percent per annum.6 A 1994 article in Fortune magazine reported that only 16 percent of 800 fixed income funds beat their relevant benchmark over the 10-year period covered.7

Of course, being a loser’s game does not mean there are not some winners. The fact that there are winners allows investors to hope that they can identify the few winners ahead of time. The evidence from a study by Marlena I. Lee of Dimensional Fund Advisors suggests otherwise.

Lee studied the performance of 2,353 bond funds over the period 1991–2008, which included investment-grade, high-yield, and government bond funds. The following is a summary of her findings:8

• Actively managed bond funds underperformed by an amount roughly equal to fees.
• Expense ratios were a good predictor of performance.
• Good past performance did not predict good future performance. There was no evidence of positive after-cost expected alphas, even in the top percentile of funds.
• Underperformance of loser funds persisted for several years. Most of the persistence in loser returns could be attributed to fees.
• Collectively, investors in active bond funds lose about 90 basis points per year, or about $1.4 billion in 2008, in underperformance.

Lee concluded: “Although some investors may believe that the higher fees associated with active management are compensation for return-enhancing abilities, the data do not show this.”

She added: “These results indicate the unlikelihood that investors can profit from investing in funds with good past performance, but they may be able to shield themselves from poor risk-adjusted returns by avoiding funds with poor past performance.”

Other studies on the subject, including those on municipal bond funds, all reach the same conclusions:

• Past performance cannot be used to predict future performance.
• Actively managed funds do not, on average, provide value added in terms of returns.
• The major cause of underperformance is expenses—there is a consistent one-for-one negative relationship between expense ratios and net returns.

The results of a 2004 study by Morningstar demonstrated both the importance of costs and that past performance of actively managed funds is a poor predictor of future performance. It tested funds with strong performance and high costs against those with poor past performance with low costs. “Sure enough, those with low costs outperformed in the following period.”9

Why did all these studies come to the conclusion that bond fund managers charge Georgia O’Keeffe prices and deliver paint-by-numbers results? The Efficient Market Hypothesis (EMH) provides the answer: the market’s efficiency prevents active managers from persistently exploiting any mispricing. And as difficult as it is for active managers to add value when it comes to equity investing, it is much harder for them to add value in fixed income investing. Let’s see why this is true.

First, with U.S. Treasury debt, all bonds of the same maturity will provide the same return—there is no ability to add value via security selection. If we restrict holdings to the highest investment grades, there is an extremely limited ability to add value via security selection—while the stocks of two companies with AAA bond ratings can perform quite differently, their bonds of similar maturity will likely produce very similar results (because credit risk is low). The higher the credit rating, the more likely it is that bonds of the same...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Acknowledgments
• Introduction
• Chapter 1: Mutual Funds: The Evidence
• Chapter 2: Pension Plans: The Evidence
• Chapter 3: Hedge Funds: The Evidence
• Chapter 4: Private Equity/Venture Capital: The Evidence
• Chapter 5: Individual Investors: The Evidence
• Chapter 6: Behavioral Finance: The Evidence
• Chapter 7: Why Persistent Outperformance Is Hard to Find
• Chapter 8: The Prudent Investor Rule
• Chapter 9: Whose Interests Do They Have at Heart?
• Chapter 10: How to Play the Winner’s Game
• Conclusion
• Appendix A: Rules of Prudent Investing
• Appendix B: Doing It Yourself
• Notes
• About the Author
• Index