Wednesday, August 02, 2006

Active Manager Alpha Study



A recent study in the debate over the superiority of active investment management vs. passive management concluded that while both strategies have their strengths, the “average” mutual fund either met or exceeded its category benchmark in 54 out of 63 Morningstar categories over the last 3 years. Though not explicitly stated, this study suggests active investment management is a superior strategy. These results are contrary to informed thinking on the topic which suggests that investment management skill is a precious commodity which is not widely available. As William Sharpe put it, “properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs”. Curious about the difference, we conducted a similar study on equity mutual funds in an effort to reconcile these two perspectives.

To measure the benefit of active management many investment managers and investors subtract the return of their benchmark from the return of their fund and consider the remainder “alpha”. However, this calculation does not account for the level of market risk implicit in the fund which may be different from the benchmark. Beta and Alpha were introduced to quantify the nature of the investment market risk / return relationship. Every fund return can be decomposed into an element of Beta and Alpha. Beta is a measure of a fund’s sensitivity to market movements and hence its exposure to market risk. Alpha is a measure of return in excess of the returns implied by the market risk or Beta of a fund. Alpha is often interpreted as the value added by the active manager. Another way to think about this is that a Fund’s Beta represents market exposures which are inexpensively available via indexing while a fund’s Alpha represents unique value which is deserving of an investment management fee. In our study we used Alpha as the metric of active management.

It is critical to utilize proper benchmarks in evaluating active management. Morningstar style boxes and the standard Russell market index benchmarks don’t always reflect the investment universes or active management strategies employed by funds classified or benchmarked to them. Therefore, in addition to using standard Russell market indices, we used style based returns methodology to develop customized style benchmarks for each fund in the study. Generally, the resulting higher category R-squareds generated by the style benchmarks over the market benchmarks indicate they provide a more reliable alpha estimate.

In past studies of the average actively managed fund, the “average” was variously expressed as; a median return, a mean return or an asset weighted return. We computed a mean average as well as an asset weighted category alpha to highlight any differences in these “averages”.

Measuring fund performance against conventional benchmarks appears to systematically overstate the case for active management. Fund alpha computed using more relevant style benchmarks is generally lower than alpha computed using the conventional Russell market benchmarks under both average and asset weighted measures. This also suggest that investors ‘on average’ may be paying active management fees for what is in part beta exposure outside of the conventional asset class benchmarks.

Smaller cap and growth funds may provide better opportunities for Alpha.This study supports the notion that less efficient asset classes such as small cap equity may hold more promise for the average active manager. Similar studies suggest that growth style investing may provide more active management opportunity than value investing. Our data seems to support this general observation.

Measuring alpha on an asset weighted basis provides a more encouraging perspective on active management than on a mean average basis. The results of the two “average” methodologies are quite different. This difference in how empirical evidence supports the superiority of active vs. passive may account for the biases held on either side of the debate. The study we mentioned earlier used an asset weighted average. It is intuitive that higher alpha funds should and apparently do attract more assets over time than lower alpha funds. It also unfortunately follows that alpha tends to deteriorate as asset size increases. At this level, the debate seems to turn on which measure best represents the average active manager, a mathematical mean or an asset weighted average.

Our intuition is that the average alpha values in the study better reflect the challenges and the opportunities available to the “average” investor seeking active management outperformance.

Through this work we can see that the outcome of historical reviews of fund results and the resulting connotations about the potential for active management are sensitive to the benchmarks utilized and the mathematical definition of the “average” active manager. The next question, of course, is whether any average or specific past performance can be useful for investment decision making? For many reasons, the sole utilization of past returns in selecting investments is not as valuable as its broad use would suggest. However, past performance in concert with other quantitative and qualitative information can be helpful in narrowing an investor’s opportunity set to a comparatively small set of actively managed funds with the potential to outperform an appropriate market index.

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