In his famous 1989 essay “The End of History?” (and subsequent book), author Francis Fukuyama argued that the the age-old battle between liberal democracy and other (more totalitarian) forms of government was quickly coming to an end. Since such battles had been the hallmark of human history, history itself was therefore coming to an “end”.
To a great extent the history of investment management (at least, since Markowitz) can be described as similarly bipolar struggle – this one between active and passive management. Efficient market theorists would argue that the final pitched battles between the two sides are being fought in the mutual fund and ETF industries – with ETF’s destined to triumph. However, proponents of active management point to the hedge fund industry as proof that active management is not only alive and well, but is consolidating its forces. Are either of these the final epic battles in the history of asset management?
A couple of news items yesterday suggest the balance of power is tilting toward the efficient market theorists. First, Mark Hulbert writes about Kenneth French’s latest paper, “The Cost of Active Management” in the New York Times. As far as we can see, the paper has not yet been released to the public. So Hulbert’s interpretation is all we have to go on for now.
According to Hulbert, French calculated that Americans spend approximately $100 billion on “beating the market” each year (investment management fees, trading commissions and bid-ask spreads). That represents about 67 basis points of all US equity assets. Hulbert says French’s figure represented the fees that exceed what a passive investor might pay to just buy and hold an index fund (around 20 bps).
Curiously, this has always represented about 67 basis points of all assets – even when trading costs were significantly higher. Ergo, as trading costs have fallen, asset managers’ “new revenue sources” have made up the difference.
“…a typical investor can increase his annual return by just shifting to an index fund and eliminating the expenses involved in trying to beat the market.”
This is a version of the familiar EMH refrain “Alpha is a zero sum game“. But this argument is seldom delivered with its important caveat – return persistence. Continues Hulbert:
“Professor French emphasizes that this typical investor is an average of everyone aiming to outperform the market â€” including the supposedly best and brightest who run hedge funds.”
In a linguistic sleight of hand, Hulbert makes it sounds as if even the “supposedly best and brightest” can’t beat the market. But an equally correct interpretation could be that the average investor – excluding the “best and brightest” – did even worse. In other words, it may well be that hedge funds are eating the average investors’ collective lunch. It all depends on the “persistence” of active outperformance – not the aggregate return from active management. It’s not news that the average investor cannot produce alpha. As Bill Sharpe pointed out, the average investor – by definition – cannot beat the market.
For example, when investors talk about some emerging market as being an attractive source of alpha, they’re not saying that a passive investment in that market produces alpha (on the contrary, a passive investment in any market is all beta by definition). Instead, such a market is generally considered to be one where an informational advantage can be persist – where the winners stay winners for longer than you might expect due to a “market inefficiency”. Eventually assets will flow from the persistent losers to the persistent winners, creating a new cohort of “losers” from those that were previously around the average.
Our “Fly on the Wall” in London yesterday similarly questioned the commonly invoked “alpha is zero sum” argument – in that case levered against hedge funds.
At the end of the day, most academics seem to now believe that markets are pretty efficient, but not perfectly efficient. This could create opportunities for (highly sophisticated) trading strategies, but probably not for the “average” investor. So we would agree with Hulbert’s general conclusion as it pertains to retail investors:
“Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.”
Anyway, when the French paper is available online, we’ll let you know. But some policy makers aren’t waiting around for that day. The second active/passive story making news yesterday was a speech by the head of a group architecting a new national savings programme for citizens of the UK. IPE reports that the Paul Myners wants to put a cap on management fees for such a plan at 30 bps (read: “index fund”). Myners told an audience in Scotland that he wants to see proof that higher fees lead to better returns. This, after one industry leader warned the gathering that 30 bps wouldn’t be enough to attract the requisite talent.
Still Myners left the door open a little, telling the audience:
“…There is evidence where managers could deliver areas of super alpha. If you can find these managers, you should probably appoint them and pay up, but in the vast majority of places, low cost is critical.”
We wouldn’t disagree. “In the vast majority of places” an ETF should be used. But in select circumstances where alpha can be generated (or at least, alternative betas can be exploited), the “low cost” route can leave money on the table.