Alpha generation: skill or chance?

For several years, the academics and market players have been questioning the performances of active management relative to passive management. It is today a hot topic in a context of sad mood in the markets and turbulence in the banking sector, as well as recent debate on the surge of ETFs (Exchange Traded Funds) offer. More than 25 years ago, professor Burton Malkiel [1] suggested that a blind monkey throwing darts at a newspaper open to the financial section would be able to select securities as well as experts. Said simply, the problem comes back to asking whether the service paid for active managers, who are supposed to beat the markets (passive management) is worth it.

The results show that 1 out of 7 managers was able to generate statistically significant out-performance in 1990, whereas at the end of 2006 there were only 1 out of 166.

Gilles Criton and Olivier Scaillet

An answer to this problem is not immediate. It requires to set a benchmark such as a stock index or a core portfolio, to develop a rigorous methodology to quantify the significance of over-or under-performance examined over a a large universe of fund managers.

Olivier Scaillet

The problem comes back to asking whether the service, paid for active management which is supposed to beat the markets, is worth it or not

In a recent study [2] excess returns generated by the 2076 U.S. mutual fund managers invested in U.S equities. were measured against several benchmark including S&P 500. The results show that 1 out of 7 managers was able to generate statistically significant out-performance in 1990, whereas at the end of 2006 there were only 1 out of 166 or less than 1%. The over-performance is measured net of investors fees. Investors here are individual rather than institutional as the latter can often negotiate fees. The gross of fees results shows one manager out of ten in late 2006.

Potential explanations of the decline in the number of out-performaing managers include the fact that equity markets are mature, therefore more efficient, and a dilution of profitability due to an increase in the number of funds from 400 to 2076 in ten years. A third explanation is the better compensation packages in the alternative industry which attracts top traditional fund managers

The difference between gross and net-of-fees outperformances can sometimes be explained by the high level of entry fees applied in mutual funds.

Gilles Criton and Olivier Scaillet

The difference between gross and net-of-fees outperformances can sometimes be explained by the high level of entry fees applied in mutual funds. Given their ability to perform a good stock picking, fund managers charge entry fees to investors and, thus, they cash in the reward of their talent [3]. Sometimes they misjudge their ability to beat the market in comparison with the fees they charge, as is shown by the number of underperforming managers - 1 out of 4 net-of-fees and 1 out of 22 gross-of-fees. This explains the increasing and more diversified offer of passive funds, such as the Index Trackers or Exchange Traded Funds The latter adopt low-cost strategies, by favouring a drastic drop in management fees during the replication of market indices.

Gilles Criton

the sub-prime crisis demonstrates the risk for an investor to be invested in a hedge fund which absorbs excess returns

The theory of erosion in performance due to the moves to hedge funds seems to be supported by a recent study on hedge funds performances of hedge funds [4].

Remember that unlike mutual funds, hedge funds have little or no regulation. They are also distinguished by the use of derivatives, short selling and leverage. These differences allow them to generate out-performance regardless of market conditions.

However, the study shows that the proportion of outperforming alternative funds is still globally weak and vary with financial market crisis (burst of the technology bubble, LTCM crisis, etc.) Before the subprime crisis, the proportion of outperforming managers ranged from 2.5 to 35.2 percent depending on the strategies studied and period under review. It also shows that the fees of a large majority of managers erased excess returns.

Nevertheless, despite the extent of the crisis, an average of one out of five alternative fund managers overperform

Gilles Criton and Olivier Scaillet

the sub-prime crisis demonstrates the risk for an investor to be invested in a hedge fund which absorbs excess returns. Indeed, the number of managers who underperform surges with proportions ranging from 47 percent to 75 percent. Nevertheless, despite the extent of the crisis, an average of one out of five alternative fund managers overperform. In comparison with other types of funds, alternative funds are therefore still very interesting.

The comparison of the merits of active management versus passive management should not only be reduced to a performance measure, and the debate can not be considered closed. The study on alternative funds also shows the heterogeneity of market risk exposures within one strategy and it can vary significantly in response to market movements. alternative management therefore requires more focused monitoring of market exposures. Other dimensions such as dependencies between financial risks, monitoring of extreme risks and investment horizons are key aspects of an appropriate investment strategy. These elements, more complex to model, are still awaiting relevant solutions.

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