If alpha is the result of confluence of manager skill and market inefficiency, then you’d expect less efficient markets like small cap equities and emerging markets to provide the best opportunities to outperform. Indeed, that’s the logic behind the common assumption that, when you “port” alpha in a portable alpha strategy, you port alpha from inefficient markets such as EAFE onto beta from efficient and mature markets like US large cap equities (by, for example, shorting an EAFE index against your active EAFE manager and using the proceeds to go long the S&P 500).
Even if you think portable alpha is a lot of hogwash, you may still subscribe to the notion that a core-satellite portfolio ought to have an “efficient-market” core and an “inefficient market” satellite.
But a recent research note from MSCI challenges that model. In it, authors Xiaowei Kang, Frank Nielsen and Giacomo Fachinotti conclude that there is actually “little evidence that average managers operating in these markets have produced higher or more persistent risk-adjusted returns relative to their developed markets large and mid cap peers.”
Rather than knocking the alpha-generation capabilities of emerging markets managers, the trio says it’s the extent of active management used – in any markets – that determines a manager’s alpha-creation, not just the markets in which they operate. In fact, they remind us of the report already discussed in a post of ours about research on Active Share. The authors of the report, Martijn Cremers and Antti Petajisto, said that,
“…funds with the highest Active Share (another measure of active risk) significantly outperform their benchmarks after expenses, exhibiting strong performance persistency.”
A high dispersion of equity returns is often assumed to lead to more successful active management. This makes intuitive sense, of course, since active managers should be able to identify the stocks with the highest (upside) dispersion. So it’s no surprise that Kang, Nielsen and Fachinotti found that emerging market and small cap managers have a higher dispersion than established markets and large cap managers. The chart below shows the difference between the five-year returns of the 25th percentile managers and those of the 75th percentile manager.
But while “inefficient” markets should be fertile hunting ground for alpha-seekers, the trio found that the information ratio of the top quartile active US small cap funds and active emerging markets funds was actually lower than the top quartiles in other, more efficient, markets. And, counter-intuitively, the three-year persistence of top-quartile small cap managers was actually lower than that of top-quartile US large cap managers.
What’s up with that? Well, the trio hypothesizes that the answer may lie in the costs of research and trading in these markets:
“[H]igher costs in portfolio management and trading as well as potential regulatory and information barriers may dampen the perceived higher opportunities for active management in emerging markets. Similarly, compared with the large cap segment, small cap managers may face higher implementation costs due to limited information flow, lower liquidity, and constraints on capacity.”
So what should an investor do? Kang, Nielsen and Fachinotti suggest throwing out the notion that “core-satellite” is a synonym for “efficient market beta / inefficient market alpha” and instead mix passive and active from any and all markets. In their analysis, a 60/40 passive/active split (in blue) actually beat a totally active portfolio where managers were only modestly active (in red).
So the bottom line is that it may be best to totally free-up a certain portion of your managers to have a very high tracking error than it is to get the same aggregate risk by allowing all your managers to have a modest tracking error. The kicker is that this rule apparently holds across all market segments regardless of any preconceived notions of market efficiency.
So next time someone disses the alpha-potential of your US large cap mandate, repeat this line from the MSCI paper:
“[T]here is no empirical evidence suggesting that perceivably less efficient markets may be associated with ‘easier’ alpha.”