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Thursday, October 8, 2009

Searching For Alpha ? Don't Look For It in An Active Mutual Funds

Kudos to Morningstar for producing an in depth study of whether active mutual funds produce additional returns on a risk adjusted basis.

Despite the fact that Morningstar's core business is to review and rate actively managed mutual funds, one has to sit up and take notice when they reach the following conclusion (although I would hardly have expected them to come up with a different result from their research).

As the WSJ reported (my bolds and italics)

While it's been established that most actively-managed mutual funds lag their indexes over time, a new study further twists the knife: Active management suffers even more by comparison on a risk-adjusted basis.

The study found that in many cases where an actively managed fund beats its index on an absolute basis, the additional risk it took didn't justify the returns they earned. Not only should that be a warning sign for investors -- because greater risk means greater volatility -- but it also suggests that fund managers aren't living up to what's expected of them.

The study by Morningstar Inc. found that while about half of actively-managed funds outperformed their respective Morningstar style indexes over the past three years, only 37% did on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns

Although few would enter into the strategy listed below, it makes perfect sense. Active managers have no consistent skill in outperforming the market yet charge for managing money much greater than and index fund. Therefore the most direct way to increase risk in the quest for greater return is to simply leverage up the index investment. Of course we know that leverage has other potential drawbacks but that is the subject that I have dealt with in outher posts.

The key to thinking of risk in terms of returns versus an index, he said, is that in theory if an investor wanted to take on more risk for greater returns, they could simply buy an index fund and lever up their exposure. That would also increase returns while adding risk -- and do so at cheaper cost to most actively managed funds. It's against this standard that actively managed funds should be judged, he said

Interestingly although I am certainly a skeptic of modern portfolio theory (MPT)
and the efficient market theory, in this case the above comment is both accurrate and consistent with that theory. If one believes, as I do, that the "weak form" of the efficient market theory is true = it is near impossible to significantly beat the market (the benchmark index) then the only way to reasonably hope generate excess return over the maket(index) return other than increasing risk through leverage.

Excuse the jargon but a portfolio composed of 100% of an S+P 500 index fund for example with 10% of the portfolio borrowed on margin and invested in the index would create effectively a 110% holding in the S+P 500. The portfolio would have an expected return of 1.1 times the index (both on the up and downside) and would have a beta (risk measure ) 1.1 or 1.1. times the risk of the S+P 500. No additional risk= no higher expected return.

Of course Morningstar's research guru can't articulate the logical conclusion from the study: ignore the idea of picking an active fund and stick to an indexed portfolio. Instead quite illogically he states:

Russ Kinnel, director of research at Morningstar, suggested investors looking for active management should head into the less risky funds.

"It's generally better to be in a lower risk fund," he said. "There's more consistency [of performance] and timing when you invest is less critical [in determining your returns]."

Human nature also plays a part, said Kinnel.

"It's harder for people to stay with funds that go up and down extremes," he said.

But Portfolio theory and the same logic that lead the Morningstar analyst to suggest that the most reliable way to avoid extreme fluctuations in a portfolio is not to try to choose less volatile actively managed funds. It is the mirror image of the
leveraged strategy described above. By increasing the % holdings of the risk free asset (tbills) and reducing the % holdings in the risky asset (the index
dex fund) one reduces the volatility of the portfolio along with the expected return.

So if investors understand their risk tolerance they can vary the percentage of their portfolio in an index fund (including leveaging to hold more than 100%)
with their holdings in risk free tbills as the most efficient and reliable way to manage risk and expected return

All of this is the bare bones of modern portfolio theory from Markowitz a basic concept that is pretty indisputable if you belief that alpha (excess reurn without excess risk) is not achievable on a systematic basis. The Morningstar study certainly seems to give evidence that alpha doesn't exist

The full Morningstar study is here
Some other pointsiliom the study:

Over a trailing five year period the odds were about even that an active fund would beat a passive one in the 9 morningstar style categories.But for both 3 and 5 year periods active funds did not add returns on a risk adjusted basis (i.e. there was no alpha)

Excuse the geekiness but Morningstar used both the Jensen and the Fama French alpha. The latter gives a better measure of how much the fund outperformed the index,rather than generating excess returns by holding assets outside its category, (he style drift I have disucess before). Using the Fama French alpha only 37% outperformed on a risk adjusted basis vs. 41% for the Jensen measure. And the Fama French alpha does not fully capture the effect of style drift.

Cash holdings are consistent across funds in contrast to the oft cited claim of those touting active funds that unlike an index active managers will know when to raise cash by selling stock and when to reinvest.

One more interesting finding: larger funds have lower alphas illustrating the well known phenomenon of closet indexing particularly for large funds. But here is an interesting wrinkle to that fact: Investors are know to chase performance, so when they learn of a fund that has performed well recently (from Morningstar,cnbc or other parts of the financial press) they rush to invest in that fund often one with a small asset base. The assets go up the fund becomes a closet indexer and whatever short term alpha might have existed is gone. Investors are chasing both performance and perceived alpha based on past data. But the likelihood is that they will put assets into the fund just when its alpha measure goes down.

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