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May 08, 2017 at 12:27 PM
The average active equity mutual fund underperforms its benchmark, an assertion that sparks little controversy. This appears to be the case for active equity hedge funds as well. The story gets even worse when the results are AUM weighted. Collectively, active equity delivers no value to its investors and in fact extracts value from them.
In our highly competitive markets, no industry can long survive if it fails to deliver value to its customers. The consequences of these competitive forces are on full display in the current environment, as money flows out of active funds and into passive equity funds. Passive investing is being touted as a superior alternative to active equity and who can argue with this given the overwhelming evidence in support of this assertion.
(Related: Strike Three: Is Index Investing Really a Swing and a Miss?)
As an active equity industry, we have to ask ourselves how we descended into such a sorry state. The conventional explanation is that portfolio managers and their investment teams lack stock-picking skill, but as is often the case, the answer is not quite so simple.
A careful analysis of the situation reveals that investment teams, buy-side analysts in particular, are not the problem; instead it is the system that sprang up for distributing funds. So rather than loudly denounce the lack of stock-picking skill, those in the distribution system have soul searching to do. As comics character Pogo was fond of saying, “We have met the enemy and they are us!”
Buy-Side Analysts Are Superior Stock Pickers
There is considerable research showing that buy-side analysts are superior stock pickers. (See, for example, Wermers (2000); Berk and Green (2004); Cohen, Polk, and Silli (2008); Pomorski (2009); Wermers (2012); Wermers, Yao, and Zhao (2013); and Frey and Herbst (2014).) The table below presents the results along this line from a study I conducted.
Active Equity Fund Best Ideas: Top 20 Relative Weight Stocks
Based on single variable, subsequent gross fund alpha regressions estimated using a data set of 44 million stock-month US active equity mutual fund holdings from Jan 2001- Sep 2014. Source: Lipper and Morningstar
These results reveal that the top 20 relative weight holdings generate fund alpha while the lowest ranked holdings destroy alpha. So any restriction imposed on a fund that leads to holdings other than best-idea stocks will negatively impact a fund’s alpha. If enough holdings are added, a potential positive alpha is transformed into an actual negative alpha, the sad situation on display today.
Conventional wisdom in the fund distribution system is full of such restrictions. Just to name a few: hold many stocks for diversification purposes, manage to low volatility and drawdown, avoid tracking error and style drift, grow large, and impose sector weighting constraints. In essence, the distribution system is a closet indexer manufacturing juggernaut.
To be clear, I and my co-author Jason Voss of the CFA Institute are talking about those who run the distribution system, both inside and outside the fund itself. The internal sales and marketing teams work hand-in-glove with the external platforms, BDs, RIAs and institutional investors, imposing value destroying restrictions on investment teams.
The “pot of gold” generated by analysts’ best ideas, somewhere around a 4% average alpha based on several studies, is eaten up by fund fees (less important) and external restrictions placed on the fund (most important). In the end, the fund itself captures the entire potential alpha and then some by growing too large, ultimately turning itself into a closet indexer. So none of the alpha is delivered outside the fund and, what is worse, additional value is extracted from investors.
