20 March 2007
The Right Answer to the Wrong Question: Identifying Superior Active Portfolio Management
By: W.V. Harlow, Fidelity Research Institute & Keith Brown, University of Texas
Published: Fourth Quarter 2006, Journal of Investment Management
The search for alternative beta aims to explain some of the unexplained magic and mystery behind hedge fund management. Once we strip these betas from a hedge fund’s return stream, we often conclude that average hedge fund doesn’t have enough alpha left over to justify its fees. Sure, some funds beat their benchmarks. But on average, many say, managers produce no alpha - or worse yet - negative alpha.
But do you need to invest in the average hedge fund (or actively managed mutual fund)? What if you were better than average at picking good managers? In this study, Harlow and Brown say we shouldn’t get obsessed with the ”average” mutual fund manager. Instead we should simply find “good” managers. They call focusing on the average mutual fund a straw-man argument - chosen by indexers because it’s easy to refute:
“…rather than judging the quality of active management solely on the basis of such factors as how the ‘average’ fund performs relative to its benchmark or where a given manager ranks relative to his or her peer group, it is our contention that investors are better served by concentrating their efforts on finding the subset of available managers who are consistently able to deliver superior risk-adjusted returns.”
But first, you would have to know if ”good” managers even exist. A random distribution of manager luck will always yield winners. But in order for outperformance to graduate from the error term in a regression to the coveted alpha term, a manager needs to be persistently lucky.
Reams of studies over the past 20 years have shown that hedge funds, and more broadly, any actively managed funds lack persistence. But the authors argue that some managers out perform expectations at rates that pure dumb luck could not possibly explain. So even though the annual returns of the universe of managers can be represented with a bell curve, some managers seem to end up on the right side of that curve more than half the time.
The researchers calculated monthly alphas for hundreds of mutual funds based on their trailing 36 month betas. They called this number “PALPHA” (Past Alpha). Then they forecasted the expected returns over the next one-month, three-month and twelve-month periods using each fund’s trailing 36 month beta. They called the difference between this expected return and what actually transpired “FALPHA” (Future Alpha). [ed: not to be confused with Average Linear Future Alpha, “ALFALPHA”;)].
Turns out, the FALPHAs were higher than the PALPHAs. This makes sense when you consider that the PALPHAs for each month were derived from a regression on those very same months. So the “best fit” regression line was, well, the best fit. But it’s not necessarily the best fit for data outside of the initial sample. As a result, forward-looking returns naturally show more “unexplained” returns.
In any case, just because a third to a half of funds showed positive FALPHA doesn’t mean you can identify high FALPHA funds before the fact, right? Apparently, wrong. The researchers regressed FALPHA against: PALPHA, expenses, AUM, turnover, diversification, & volatility and concluded:
“The preceding analysis provides clear evidence that investment performance persistence is a statistically significant and identifiable phenomenon that depends on a multitude of observable factors.”
In fact, the two best predictors of FALPHA were PALPHA and expenses:
“…both a fund’s past performance and its expense ratio are especially important controls to take into account when selecting a manager. Focusing on the best manager cohort defined by these two variables increases the investor’s odds of choosing a superior manager from considerably less than one-in-two to better than breakeven; the odds increase further to three-in-five when additional controls for fund turnover, risk, and assets under management are employed in the selection process.”
But in the end, positive alpha doesn’t mean positive returns. And in the mutual fund industry, positive returns sell. In fact, in the conclusion to their paper, the researchers lament how most investors “chase funds with the highest total returns“:
“…our selection process is not representative of the techniques typically employed by intermediaries who service the investment market. In fact, Morey (2005) demonstrates that more easily observable measures of fund quality (i.e., a five-star Morningstar rating) may not be a reliable indicator of superior future performance. Second…it is possible that investors do not have a clear understanding of what constitutes true outperformance, opting instead to merely chase funds with the highest total returns in the immediate past (see Capon et al., 1996). However, many funds that attract incremental flows due to higher past returns may simply be taking more risk; Grinold and Kahn (2000) and Waring and Siegel (2003) caution that investors must be able to distinguish a fund’s actual alpha from its beta (i.e., systematic risk) to identify superior managers.”
So whither indexing? Well according to this study, it’s definitely a more efficient way for dart-throwing monkeys to ply their trade:
“…the preceding analysis makes two conclusions abundantly clear, (i) there is a place in an investor’s portfolio for the properly chosen active manager; but that (ii) the investor who selects funds in a random manner will find indexing to be a better alternative.”
Hold on, you say, if certain managers consistently out performed, capital would flow to them and away from persistent losers. The persistent losers would eventually shut down and the median would rise until, once again, half underperform and half out perform. So persistence implies some kind of disequilibrium in the asset management industry. In other words, investors seem to support the losers, keeping them in business and allowing winners to persistently beat the resulting lower median.
Fund marketers will often refer to investor “stickiness” (a.k.a. “patience”). We suggest this very stickiness creates (or at least contributes to) the enduring disequilibrium.
- Alpha Male