Your Active Manager: More Effective, Cost-Effective, Yet Less Successful

By James Saft

Every year, active fund managers become more skilled, well-trained, and cost-efficient, yet they face increasing difficulty in outperforming the market. It’s not necessarily that alpha—investment gains from outperformance—is vanishing; instead, the less informed investors are slowly leaving the scene. As more capital shifts to passive investment strategies, the potential gains at the expense of less knowledgeable investors decrease, making it increasingly challenging to achieve alpha.

Similar to what many poker players realize, having fewer uninformed players at a table means that winning from the remaining skilled players becomes much tougher.

Analyzing the performance of hedge funds and mutual funds reveals a long-term trend of underperformance that appears to be steepening. Between 2006 and 2016, a staggering 82% of large-cap managers, 87% of mid-cap managers, and 88% of small-cap managers in the U.S. failed to meet their benchmarks, according to data from S&P Dow Jones Indices.

Furthermore, the Active/Passive Barometer from Morningstar, which tracks only those funds that have survived, shows a grim outlook for the industry. Over a decade, only 17% of large-cap growth funds were able to outperform their passive counterparts. Alarmingly, only one out of 22 categories, specifically U.S. Mid-Growth funds, surpassed a 50% success rate in terms of outperformance.

Hedge funds are reporting a similar trend. The HFRI Fund Weighted Composite Index demonstrated a decline of 0.18% over the past year and achieved just 2.68% in annualized returns over the last five years while broader market indices more than doubled in total returns. None of the over 60 indices tracked by HFRI managed to generate even half the total return of the S&P 500 during the same timeframe.

Some may argue that the last decade has been extraordinary, primarily due to market bubbles and indiscriminate valuations resulting from central bank interventions. While this is a valid point, it offers little solace to those who would have been better off with more cost-effective and lower-risk alternatives.

Alpha Is a Zero-Sum Game

In a recent commentary marking his 30 years in investment, Michael Mauboussin pointed out that the share of assets managed passively has surged from less than 1% to about 35% during that period. His key argument is that relative skill, rather than absolute skill, is what counts in investment management now.

He noted that the gap between top performers and average ones has narrowed compared to previous generations. This is evidenced by the steady decline in the standard deviation of excess returns for mutual funds over the past 50 years. The significant shift from active to passive investing intensifies this effect. For every positive alpha generated, there must be an equal amount of negative alpha elsewhere, meaning that as weaker players exit the market, the conditions for strong players to generate excess returns become increasingly challenging.

The clear trend indicates that more assets will continue to flow into passive strategies, forcing less capable managers out of the industry, while pressure on fees remains strong. Technological advancements will only expedite this process, making it easier for clients to transition to more affordable options.

Nevertheless, alpha still exists, and people will persist in pursuing it while willing to pay for it. Some of these investors and the active managers they hire will indeed find success.

Interestingly, a significant market selloff could present a medium-term opportunity for active managers. During such downturns, passive strategies may suffer steep losses, while some actively managed funds could outperform. Although this wouldn’t alter the underlying dynamics of alpha being a zero-sum game, it could temporarily reverse the prevailing trend.

(James Saft is a columnist. The opinions expressed are his own.)