Advisor Blog

The book entitled “The Quest For Alpha” by Larry E. Swedroe presents comprehensive evidence documenting the futility of active portfolio management by examining the quest for money managers that are capable of delivering alpha¹.  Swedroe references academic studies on mutual funds, pension plans, hedge funds, private equity/venture capital, individual investors, and behavioral finance.  He demonstrates that markets are indeed highly efficient and makes the ultimate conclusion that the only winning move is not to play the game.  Girolamo Cardana who was a sixteenth-century physician, mathematician, and quintessential Renaissance man made the same conclusion for gambling (which is quite similar to active management) when he said “The greatest advantage from gambling comes from not playing at all.”

Referenced in the book, Philip E. Tetlock, a professor of psychology, business and political science at the University of California (Berkeley) found that the so-called experts who make prediction their business – appearing as experts on television and talk radio, being quoted in the press, etc. – are no better than the proverbial chimps throwing darts.  His research indicates that it makes no difference whether forecasters are PhDs, economists, political scientists, journalists, or historians; whether they had policy experience or access to classified information; or whether they had logged many or few years of experience in their chosen line of work.  The only predictor of accuracy was fame, which was negatively correlated with accuracy.  The most famous made the worst forecasts.  All of these so-called experts seem to fall victim to hindsight and/or confirmation bias.

I strongly encourage you to read the book for the deeper discussions and supporting research that examines the dismal results of active management in its multiple forms.

1. If an asset's return is even higher than the risk adjusted return, that asset is said to have "positive alpha" or "abnormal returns". Investors are constantly seeking investments that have higher alpha.

In another interesting Dow Jones article, the author points out that "the pain from the recent market downturn was felt far and wide—but not shared equally" and that "the classic type of mutual fund, which employs an army of stock pickers to invest in big U.S. businesses, has fared a lot worse than low-cost index funds which simply ride the ups and downs of the market."

That's not news to us, but it is apparently news to a lot of people.  According to the article, investors have pulled more than $174 billion from U.S. large company stock mutual funds in the last three years and, in fact, these funds haven't experienced a positive flow since June 2009.  Some of the industry's best-known names have bled investment dollars, including American Funds Investment Company of America (-$16.1 billion), Dodge & Cox Stock Fund (-9.1 billion), and Fidelity Contrafund (-$1 billion).  In contrast, index funds have suffered much less.  Large company stock index funds and ETFs have actually seen inflows of more than $147 billion in the last three years while actively managed funds were hemorrhaging.

This trend vindicates many investing experts and academics who have long questioned why individual investors pour money into actively managed funds that, as a group, seem unable to beat the market.

Before we celebrate, though, it is worth pointing out that individual investors have continued to chase performance in the "hot" areas of the market, particularly in emerging markets stocks and bonds.  That being said, it's also interesting to note that the best performing emerging markets stock fund in the Morningstar emerging markets category (based on load adjusted 10 year annualized return) is DFA Emerging Markets Value, a passively managed fund.  Oh, and we've been using this fund in our portfolio constructions for many years.

Numerous studies chronicle the bad behavior of typical individual investors that seem doomed to buy just before a crash and are drawn into buying the most recently fashionable sector at its peak.  But, are "sophisticated" institutional and wealthy hedge fund investors any different?

An interesting new study by the European School of Management examines how investors allocated money to hedge funds from 1994 through 2004.  Baquero and Verbeek, in "Style Investing: Evidence from Hedge Fund Investors", found that recent performance was the most prominent reason for the selection of a particular hedge fund and that for every 1% of extra return over the past three quarters, the average fund attracted an additional $9M in new assets.  And, predictably, the study also finds that "there are no significant differences in subsequent performance between those styles favoured by investors and those less favoured."

It seems that much like the supposedly dumb small investor, pension funds, endowments, and wealthy investors ended up chasing past performance - one of the behaviors that we have long known produces underperformance.  Such behavior is much more likely to reward the hedge fund managers than their new clients.