Book Review
Searching for Alpha
Why do mutual fund managers
underperform?
by Joseph Dancy
LSGI Advisors, Inc.
March 25, 2004
Searching
for Alpha: The Quest for Exceptional Investment Performance
by Ben Warwick
224 pages, John Wiley & Sons; May 2000
List: $29.95; $20.97 at Amazon.com
Most
active investment managers underperform the major market indexes
according to Ben Warwick, author of a book on this issue entitled
"Searching for Alpha."
While the goal of beating the major market indexes may seem relatively easy, Warwick notes that of the 45 largest stock funds only one has beaten the Standard & Poor's 500 index over the five years ending in 2000 - and that fund outperformed by a scant 0.60% per year.
Warwick notes that because of the well documented underperformance of actively managed accounts many investors have been attracted to index funds. Index funds by definition neither under- nor over-perform the market. Approximately 35% of all pension funds are now indexed by money managers, and this percentage continues to increase each year.
In Search of Alpha: Why Do Managers Underperform?
According to academic theory the risk adjusted excess returns generated by the active investment manager is referred to as "alpha." Recent academic studies indicate that the ability of an investment manager to generate alpha - excess returns - has "dissipated dramatically" since 1970.
While managers have greater difficulty generating excess returns, the amount of money being actively managed has grown explosively. Pension fund equities under management have grown from around $1 trillion in 1990 to approximately $4 trillion in 1998 (and are certainly higher now).
Is their a correlation between the amount of assets being managed and the difficulties generating alpha? Warwick thinks a strong correlation exists.
* The Efficient Market Hypothesis & Impact of the Asset Class
Because of the amount of money under management has increased so dramatically, Warwick claims that institutions generally adopt a strategy targeting larger companies as investment candidates.
"The huge armies of analysts who cover these stocks make the sector tenaciously efficient," and he notes that this efficiency has made it "doubtful that any large-cap manager has the skills to consistently beat the S&P 500 index."
A number of studies back up Warwick�s point. Nobel price winner and Professor Eugene Fama�s studies (and numerous others) indicate that a portfolio�s performance is primarily a function of the investor�s choice of assets. On that note, a 1986 study by Brinson, Singer, and Beebower that found the following �determinants of portfolio performance�:
Asset
allocation/asset mix � 91%
Security selection/other - 9%
They conclude the most important decision an investor makes is how to divide up investments between different asset classes � that is how to allocate capital between cash, money market funds, T-bills, bonds, large capitalization stocks, small capitalization stocks, real estate, gold, art, antiques, timberland, oil & gas, etc.
This allocation decision will have more impact on the total return of a portfolio than the actual stocks or funds the individual chooses to add to the portfolio. Investing in larger, more liquid, companies in the past has yielded historical returns below those in other asset classes.
Conflict of Interest
According to Warwick, other reasons that active managers underperform the market is because their interest is not always aligned with that of their investors. Active money managers are generally compensated on a percent of assets under management, not by performance.
The more money actively managed, the more difficult it is to beat the market indexes according to Warwick. But assets under management, not performance, is the main focus of most fund companies and their advisors.
Warwick also notes that studies have cited other reasons for the underperformance of actively managed accounts: investment constraints, efficient markets, fees, conflicts of interest, transaction costs, short-term investment horizons, among others.
And since the book was written, we have seen other potential reasons for poor performance including short term trading, excess soft dollar payments, and outright late trading of fund shares.
Conclusion
Warwick does a good job at walking the reader through some of the strategic issues an investment manager faces, and details the problems actively managed mutual funds have in consistently outperforming the market.
The fact is that many, if not most, public mutual funds grossly underperform the major market indexes after costs and expenses � to say nothing of the adverse impact of taxes. Public funds attract investment dollars from individuals due to their massive advertising and marketing efforts, which helps support the financial press and publications.
If Warwick is on point � and we think he is � equity investors would be well placed to invest in low cost index funds. Or, if their risk tolerance provides, in asset classes that have historically outperformed. For the serious investor "Searching for Alpha" is well worth reading.
© 2004 Joseph Dancy
Bio
& Archive
Contact Information
Joseph Dancy, Adjunct Professor
Oil & Gas Law,
SMU School of Law
Advisor,
LSGI Market Letter
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