Generating Alpha: Skill or Luck?

Key Points:

• The statistics show a small number of active funds regularly outperform their benchmarks.
• Having prospectus flexibility and tracking style factors can increase the odds of outperformance.
• Anchoring to large addressable markets and great businesses further increases the odds.

The media loves to create headlines designed for shock value. In general, we know the body of evidence suggests the vast majority of active equity funds regularly underperform their benchmark. But hidden under the headlines are key reasons why this is true and how an investor might increase the odds of finding funds that have a history of more consistent outperformance versus an index. In my opinion, the headline is less important than the reasons why underperformance tends to happen.

The chart below from S&P Dow Jones Indices shows the percent of active equity funds that are outperformed by their respective benchmarks. ETF providers love to use a table like this but when you consider there’s typically one thousand funds for every style box a category showing only 20% win rates for active still allow those who do research to find about 200 funds that invest in a theme you agree with and have performance that has been exemplary versus a benchmark. Those trying to sell against active funds rarely point this quick math out in their narrative. There’s plenty of opportunity to buy strategies that have an edge over a passive benchmark.

There are a few key reasons a strategy might underwhelm investors. If I were going to describe the why in a few phrases it would be “a lack of flexibility and being style-stubborn.” Let us flush these concepts out further.

I want to be clear, for the record, if the goal is attractive and more consistent performance while providing a better ride along the way, having a significant amount of prospectus flexibility is the single best advantage a fund manager can have. Below, I highlight a few of the dilemma’s the vast majority of active funds face when trying to meet their lofty goals.

#1: The style box dilemma.

Most funds manage to a particular style-box: value, growth, dividend growth, high dividends, etc. We don’t see much talk of this in our business but for the most part, different styles work better than others during different parts of the business cycle. Style factor tracking is a key X-factor for investors yet very few of them track factors to see what is being rewarded in markets. If you know what type of stocks are being favored with flows, you have the opportunity to tilt your portfolio to these style factors which can help allow for better performance. Our team focuses on style factors in a very big way to help drive our sector and stock selection.

#2: The market-cap dilemma.

This concept is similar to the style-box dilemma and jives with the style factor tracking. Sometimes, a certain size company tends to perform better than another. We can always attempt to figure out why something is happening so we can predict better when the trend might change but why not be willing to invest in the types of businesses being rewarded? If you aren’t stubborn with regard to factors like market cap and style, your odds of more consistent performance should increase.

#3: The geography dilemma.

I think you know where I’m headed with this line of thinking. Why limit yourself if attractive returns and a better risk/reward outcome is your goal? I have written before in these blogs that asset allocation could be compared to golf where the assets, we can invest in are the golf clubs in your bag. If you had to guess, would most golfers have a better average score if they were forced to use every club in the bag or given the flexibility to use only the club(s) they thought were best for the course, weather and personal skill of the golfer? I think the flexibility to be more concentrated by club might offer a better opportunity for a solid score if it were offered. The same is true in our geographic dilemma.

Let’s visualize these concepts better with a few charts from Callan Research. The first image below highlights by calendar year, a list of popular asset classes and ranks them according to the best and worst performing. In 2019, U.S. large cap equities were the top performer but in 2018 these stocks were middle of the road and returned a negative number.

Being forced to stay in a box almost assures periods of underperformance as style dominance changes.

Source: Callan

The second Callan image below highlights by calendar year, a list of popular styles and geographies and ranks them according to the best and worst performing. In 2019, U.S. large cap value equities were the top performer but in 2017 value stocks were a big laggard while Emerging Market Growth stocks led the pack. With few exceptions, staying in a box often assures a lack of consistent relative performance. If you own everything all the time, the weak styles water down the performance of the strong.

Doesn’t your portfolio deserve a few allocations that are flexible and that avoid being dedicated to a “style box”? 

In a world with high uncertainty, doesn’t your portfolio deserve a few strategies that have the ability to dial up or down equity exposure?

#4: The sector dilemma.

Whether we admit it or not, human beings have biases. In this business, biases tend to hurt versus help our ability to offer consistent returns that beat a benchmark more frequently. Just like with styles (value or growth), size (large, mid and small), and geography, the sectors and industries one has a bias towards can help or hurt our ability to meet desired targets. One of the key reasons many funds underperform is they are not investing in the right sectors or industries that offer the best long-term opportunities.

Most investment portfolios are chronically underweight the consumer stocks. It’s always been a mystery to me given the consumer accounts for 70%+ of our country’s GDP and 60% of world GDP. A phenomenon this large and predictable is quite possibly the most logical and easiest core equity decision someone can make. Here’s the fun part: looking backward, the Consumer Discretionary Sector has significantly outperformed the S&P 500 since the indices were created in late 1998. That is over 20 years of data to lean on. Logically speaking, a consumer-led economy, that is growing more often than not, should in theory offer solid investment returns. Below I show the S&P 50 Index compared to the S&P Consumer Discretionary Sector since December 1998:

Source: Bloomberg

SUMMARY:

Here are some key takeaway points for investors:

• There is a small but sufficient number of active strategies that have high benchmark beat-rates.
• The key reasons most active funds underperform the benchmark include:
  • Style rigidity;
  • Size rigidity;
  • Geographic rigidity; and
  • Sector bias.
• Luck is being a growth manager in a market where growth stocks are outperforming.
• Skill is doing the style factor research and making an active decision to overweight growth when this style is working.
• Skill is also being willing to pivot from one style and move to an emerging performer when the evidence suggests its prudent.

Disclosure:
This information was produced by and the opinions expressed are those of the author as of the date of writing and are subject to change. Any research is based on the author’s proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however the author does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios managed by the author, and do not represent all the securities purchased, sold, or recommended for client accounts. The reader should not assume that any investments in sectors and markets identified or described were or will be profitable. Investing entails risks, including possible loss of principal. The use of tools cannot guarantee performance. The charts depicted within this presentation are for illustrative purposes only and are not indicative of future performance. Past performance is no guarantee of future results.