AgPa #35: Rethinking Active Management

Measuring skill in the mutual fund industry (2015)
Jonathan B. Berk, Jules H. van Binsbergen
Journal of Financial Economics 118(1), 1-20, URL/SSRN

Active Managers are Skilled: On Average, They Add More Than $3 Million Per Year (2016)
Jonathan B. Berk, Jules H. van Binsbergen
The Journal of Portfolio Management 42(2), 131-139, URL

We really try and destroy our previous ideas.

Charlie Munger, 2016

From several of my earlier articles you may (correctly!) gained the impression that I am somewhat skeptical about the value-add of most (not all!) active fund managers.[1]See for example here, here, and here. As I am also just a human being, it is sometimes hard for me to kill such existing ideas and views. Especially when they are based on sound empirical evidence. However, an excellent episode of the Rational Reminder Podcast featuring Jonathan Berk and Jules van Binsbergen convinced me of another perspective. In this week’s AGNOSTIC Paper, I will therefore look at one of their most successful papers.

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

The general view about active management in the finance literature is not a good one. There are countless empirical studies which document that most active managers fail to beat their benchmarks. The majority of investors are therefore probably better off with cheap market-cap weighted index funds. Apart from the empirical evidence, there is also the intuitive Arithmetic of Active Management of Bill Sharpe (1991). The important result of this thought experiment is that, on average, investors should expect active managers to underperform by the amount of fees they charge.[2]Although Sharpe’s logic is a very good starting point and probably a good way to think about active management for most people, it is a little too simplistic. Most prominently, Lasse Pedersen (2018) shows that there is space for active management because even Vanguard and BlackRock must trade with someone to maintain their passive funds.

The methodology of existing studies is almost always the same. Researchers collect a sample of active funds, adjust returns by the performance of an appropriate benchmark and/or academic risk-factors, and compute the risk-adjusted outperformance or alpha. You can do this exercise both before (gross) or after-fees (net). While net returns are obviously what matters for investors, most researchers use gross outperformance to assess whether active managers are skilled. If a manager outperforms before fees, this suggests that she has skill to extract outperformance from markets. What fee she charges is a separate decision (more on that later).The results of the literature are very consistent across regions, time periods, and sometimes even asset classes. Most studies find no statistically significant outperformance for active funds and thus conclude that the majority of investors should go passive.

Depending on your stance on market efficiency, you may conclude that most of the investment industry is useless and shouldn’t exist. This, of course, is contrary to what we observe in reality (the investment industry exists and is quite large). So how can we align these empirical results with reality? If active manager are indeed not useful, this has two strong implications. First, investors are kind of dumb because they don’t put their money in passive index funds. Second, the investment industry is entirely inefficient because it (highly!) compensates people who don’t add value.

Both implications are fairly strong and may cause a purpose-crisis if you are (like me) working in the investment industry. However, there is also a third option to save the existence of active manager (and our psychological well-being). While we cannot deny the empirical results, maybe outperformance and alpha is not the appropriate way to measure the value-add of active managers. I know this was a long introduction, but this is exactly the idea of this week’s paper.

Data and Methodology

A substantial part of the paper is theoretical modeling, but the authors also bring their results to the data. For this purpose, they use the CRSP mutual fund database for the period between 1962 and 2011. Most importantly, the CRSP database is free from survivorship-bias. Moreover, the authors also combine the CRSP data with information from Morningstar to address some weaknesses. They also manually correct errors to improve the data even further. The final dataset consists of 6,054 funds that were available for US investors.[3]The funds in the sample are only available to US investors but also hold international stocks. According to the authors, this database was quite unique and more comprehensive than other research at the time of writing the paper.

Important Results and Takeaways

Alpha and outperformance alone do not measure skill

The key idea of the paper is actually quite simple but also somewhat provocative. The authors argue that net alpha (i.e. risk-adjusted outperformance after costs) is not the right way to measure the skill of active fund managers. Let me explain.

Suppose you have two active managers. One manages $10M and generates net alpha of 10% per year. The other one generates only 1% alpha but manages $1B. Who adds more value? If you follow the conventional literature, the answer is clear. The first manager achieves ten times more alpha and thus appears more skilled. Well, yes and no. Finding an opportunity that yields 10% alpha per year is obviously a great achievement. But in absolute terms, the first manager “just” adds value of $1M per year.[4]$10M AuM x 10% Alpha = $1M Value Added The second manager earns only a tenth of the alpha, but she does that with 100 times more capital. So in aggregate, the second manager adds value of $10M per year. Ten times more than the better performing first one.

Based on this argument (and a bit more math), this week’s authors argue that we should not measure the value-add and skill of active managers by alpha and outperformance alone. Instead, we also need to consider the assets under management (AuM) and measure their outperformance in absolute dollars. As a consequence, the authors use the absolute gross alpha of funds as measure for manager skill. They compute it according to the following formula.[5]I apologize to all readers who were happy that they must never deal with formulas after graduating. But I think this one is rather harmless.

This is simply the gross outperformance of the manager but expressed in absolute dollars instead of percentages. For some of you, using gross returns may appear counter-intuitive because it implies that a manager who doesn’t produce net alpha but charges fees still adds value. I understand this criticism. The idea is that managers who beat their benchmark before costs are skilled in the sense of producing outperformance. If gross outperformance doesn’t translate into net outperformance for investors, this is not a problem of skill but of overcharging. That’s the subtle difference between unskilled and unethical…

The average active manager added value – $3.2M per year

The authors apply their absolute skill measure to the sample of 6,054 mutual funds. To compute gross outperformance, they use investable low-cost index funds from Vanguard for the respective region or styles. Back then, this was also a novel approach in the literature. Most studies use theoretical factor models to determine gross alphas. While this is theoretically correct, it is unrealistic because most investors can only decide between the active fund or its passive benchmark. Few have access to implementations of academic long-short factor portfolios.

The results are quite surprising. The average fund in the sample generates significant gross outperformance of about $3.2M per year. This result is also robust with respect to the benchmark and holds for both the Vanguard index funds and the academic four-factor model.[6]The authors use the Fama-French 3-factor model plus momentum. Sometimes also labeled Carhart four-factor model.

However, as we know from the extreme concentration of stock markets, averages can be very misleading. This is no different for the value-add of mutual funds. The average value-add of $3.2M per year corresponds to the 90th percentile. So 90% of funds are below average in terms of value-add. This is again a pattern of concentration: 57% of funds destroyed value, but a few big winners turn the average net positive.[7]Admittedly, it is less extreme than for single stocks. But it goes in the same direction.

Investors identify and reward value-adding active managers

The authors argue that this concentrated distribution has an interesting implication for the behavior of mutual fund investors. Given that the largest funds create most of the value, investors seem to identify skilled managers and reward them with more assets. In absolute dollar terms, skilled managers therefore earn the highest compensations as a constant percentage fee is applied to more and more assets. The absolute level of fee compensation also tends to predict the future value-add of mutual funds which is some evidence for persistent skill among active fund managers.

Most importantly, however, the results suggest that mutual fund investors are not “dumb” and invest with active managers against all empirical evidence. Most of the money sits in large funds of skilled managers. Yes, there are still a lot of active managers who don’t add value. But in aggregate, investors don’t allocate much money to them. While this is still not the theoretical ideal (unskilled managers should entirely disappear), I think these results are promising.

Active managers still overcharge – net alphas are negative

Okay, so far we have seen that the typical conclusion of the literature on mutual fund performance is not completely right. When (correctly) measured via gross outperformance in absolute dollars, there is compelling evidence that active managers are skilled and add value. However, we still have the empirical result that net alphas are negative. So how does this fit together?

The answer is easy. When managers generate gross outperformance but net underperformance, they simply charge too much. The authors show that the value weighted net alpha of the funds in the sample amounts to about -0.95% per year. That is pretty close to the fee of active mutual funds which is typically somewhere between 0.5% and 1% per year. Also note that this result is very similar to the paper about European mutual funds that I summarized some months ago. Gross outperformance but net underperformance. Fees are simply too high and even with skilled managers, investors shouldn’t expect too much outperformance from active management.[8]If you remember the introduction, I clearly need to give a confirmation bias disclosure at this point. But as we will see in the conclusion, the investment industry is (in my opinion) currently changing for the better…

Conclusions and Further Ideas

I think the most important takeaway of this week’s paper is that we shouldn’t be too hard with active managers. It’s easy to conclude that the whole investment industry shouldn’t exist when we see the compelling evidence against active management. In my opinion, the authors provide a refreshing perspective on the issue and clearly show that this view is probably too extreme. Yes, the majority of funds do not beat their benchmarks and destroy value. However, the managers who command the most capital tend to be skilled and outperform their benchmarks before fees. This also suggests that investors successfully distinguish between charlatans and truly skilled managers.

These were the good news. But the problem of too high fees remains. By all their defense of the investment industry, the authors still show that aggregate net alphas are negative. So yes, the investment industry doesn’t consist of charlatans who extract profits without being skilled. But it does consist of smart professionals who tend to overcharge for their services and apparently know how to use their skills for their own advantage.[9]In some (libertarian) sense, this is not reprehensible. Investors do have access to cheap passive alternatives and no one is forced to invest with active managers. So if someone is willing to pay the high fees, why not collect them? This is not the most sustainable strategy for a thriving asset management business, but it may work for some time. Maybe I should add that this is not my personal view!

There’s no investment process so good that there’s not a fee high enough that can’t make it bad.

Cliff Asness, 2015

To be fair, there are (in my opinion) two important points to consider. First, things are changing for the better. Due to the rise of passive index funds, cheaper trading, technology, etc., fees came down massively over the last years. If you put in some work you can find honest managers who offer active strategies for relatively low fees.[10]See for example my Seeking Alpha articles. Nowadays, you also get quite cheap exposure to well-known strategies like value or momentum. I think all of this is great for investors!

Second, always keep in mind that such studies look at summary statistics. Just because the average fund doesn’t generate positive net alpha, that doesn’t mean the entire industry is useless. There are and there will always be smart managers who also outperform after costs. The challenge is to find one and, even more important, don’t pay too much fees.

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