Debunking Alpha: Why Evidence Based Investing Will Prevail

Index investing is the most rational starting point for investors to begin building portfolios. This should not be a controversial perspective. Despite the overwhelming evidence supporting this premise, there remains a conflict of interest in the way that money is being managed and investments are being marketed. As long as there is a dollar to be made in marketing the golden goose of high returns with low risk, the focus and expense will continue to be devoted to the relatively minor factors of stock picking and market timing – the two activities that line the pockets of the big end of town. Despite the fact that these two activities only account for a negligible proportion of the total return achieved in a diversified portfolio, scorn will be poured on anyone who should dare possibly say it should be otherwise.

A large proportion of the profit that is generated for providing investment services is sourced from speculative pursuits and enticements using relatively short-term recent performance to encourage participation. It requires an enormous amount of intellectual honesty for an investment professional to acknowledge the futility of so much of the investment industry’s activities. The evidence is available but ignored by the majority of participants for commercial reasons. It is frightening to acknowledge that a career can be built on such a false premise. However, the discovery of the truth and overwhelming evidence to support that truth carries a moral imperative that compels investment professionals to address these issues once they become aware of them.

A passive management methodology aims at acquiring securities that replicate a specific index and then holding the portfolio over the long-term. There is no effort to pick winning stocks or time markets. Portfolio managers who take this approach simply aim to maintain close correlation with the chosen index, which means that their trading is limited to the adjustments necessary to take into account the changing characteristics of that index, by including emergence of new companies within the index and excluding companies that no longer fall within the parameters of the index. In doing so passive managers have the goal of obtaining returns that reflect that of their chosen benchmark.

Active managers on the other hand take the view that they can provide investors with a return over and above the index. Ultimately, they hope to provide investors with superior results through their superior analytics and forecasting abilities by timing trades, overweighting companies they expect to perform well and underweighting or excluding companies they expect to perform poorly.

Ultimately how well a manager performs over the long-term will come down to how efficiently they allocate their risk budget. The return you get is the reward for bearing risk. For such a simple statement, it is often confused and misrepresented. As risk is far from a simple concept and not all risks are equal. The index style of investing essentially accepts market risk as a given. Active managers on the other hand, do not. They claim they can combat this risk with skill and in doing so provide a measured outperformance over and above market rates of return.

But extraordinary claims require extraordinary evidence. Let’s review three of the most common claims made by active managers and contrast these claims with the available evidence:

1.    The first claim is that active managers can choose the good stocks and leave out the bad ones.

The core of this claim is the fact that index investors, by buying the market, will inevitably have to include the poor performing companies in their index exposure along with the good companies. Naturally, the opposite proposition of only holding good stocks in a portfolio is a compelling alternative. However, cherry picking good stocks is a near impossible task. The University of Chicago’s Booth School of Business established the Centre for research in Security Pricing, referred to as the CRSP data base. This is the largest and most comprehensive historical database in stock market research. Of the 25,300 companies that appear in the CRSP database since 1926, only 4% of them accounted for all of the total wealth creation in excess of treasury bills. Of these, just one third of one percent collectively accounted for half of the returns achieved above treasuries. And just 5 companies in the CRSP database were responsible for 10% of total wealth creation. In light of these numbers, the futility of picking winning stocks starts to become clear. Despite the overwhelming odds being known to active managers, the search for El Dorado continues as long naïve investors place their faith in others stock picking abilities.

2.    The second claim is that Active management can protect investors in times when markets fall.

The crux of this claim is that while an index investor benefits from market rises, they will also have to endure every fall that the market experiences. To mitigate this, active managers declare that through careful analysis and instinct they can shield you from market downturns. This sounds like a good deal. But the evidence that managers can make good on this promise is dubious at best.

The best case for this that I could find was Morningstar’s 2018 review of the rolling 36-month performance of US active managers from 1998 through to 2018. Ultimately, they found that on average 60% of active managers outperformed in “down years” compared with just 32% of active managers outperforming in “up years.” Interestingly, of the 60% of funds that did outperform in a given 36-month contraction, only one third of these outperformed in the subsequent 36-month period. Beyond this, there was a distinct downward trend of the percentage of manager outperformance over the period of this study.

This downward trend doesn’t necessarily indicate that active managers are becoming “worse” at their job, I would argue the opposite is likely true. It is because they are so very good as a group at processing all known information that there is little room to profit in advance from glaring inconsistencies. An investment manager can only beat the market if he or she can consistently identify mispriced securities and take advantage of the mispricing after the costs of trading. This seems to be increasingly difficult, with greater market participation and the inclusion of emergent technologies.

In it’s conclusion, the authors of this study asserted that active managements poor recent track record could be to do with the fact that in the decade up until 2018, markets had been going from strength to strength thereby limiting the opportunity for active managers to provide measured outperformance. They speculated that in future, when markets contract, active management may provide investors with more favorable outcomes.

So, let’s fast forward to 2022. Over this calendar year we experience significant geopolitical disruption and combative measures from central banks to offset increasing inflation. This led to the worst year in equity markets globally since 2008. 78% of US bond funds recorded their worst year ever. It was a scary time to be invested and was a time where active managers were finally supposed to have their time in the sun.

Standard and Poor’s index vs active scorecard, commonly known as SPIVA, published the results. Over the 2022 calendar year:

51.% of US active managers underperformed. In Canada 51.90% underperformed. Here in Australia 57.60% underperformed. And in Europe, an astounding 86.70% of fund managers underperformed their benchmarks.

The truth of the matter is that 12-month or 36-month periods tell us next to nothing about a managers value. To be fair, we would need to expand our analysis over longer time periods. Which brings us to our third and final claim:

3. Active managers can provide investors with Alpha.

Alpha is the term used by active managers to describe the measured outperformance that they can achieve over and above the index. This is the preeminent measure of a managers skill, with a positive alpha indicating outperformance over and above the benchmark return.

Thankfully the SPIVA scorecard has been running for some time. If we were to expand SPIVA’s results over 15 years, we find that alpha is in fact an elusive pursuit:

Over 15 Years 93.4% US managers underperformed their benchmark. With similar results in Canada, Europe, and Australia with 84.9%, 89.7% and 83.6% of managers underperforming their benchmarks respectively. We begin to see the alpha narrative dissolve by looking over more reasonable time periods. Importantly, it is worth noting that even over fifteen years, we would still statistically expect some managers to have beat their benchmark just through sheer luck. In fact, statistically, it would take decades of measured risk adjusted outperformance to conclusively say that manager skill was the influencing variable.

In reality, there is no evidence to support the existence of skilled portfolio managers. This truth has been known but ignored at least since 1997 when Mark Carhart published the paper titled “On persistence in mutual fund performance” and found that any outperformance by mutual funds is in fact explainable by common factors in stock returns such as size, value and momentum and not by manager skill. Unfortunately, for many money managers, the truth is not allowed to get in the way of a good story. Or more accurately, the truth is not allowed to get in the way of profit. As long as there remains a market for misinformation, sprookers will persist in contending for the public's investment dollar.