The Premature Death of Alpha

Transcription

1 The Premature Death of Alpha Source: The New Yorker You faked your death once before how do I know you re not faking it now? Harry Marmer, CFA, MBA Executive Vice President /hmarmer@hillsdaleinv.com February 9, 2017

2 The Premature Death of Alpha What is Alpha? Who Are The Culprits in the Death of Alpha? The Three Fundamental Laws Driving the Active/Passive Investment Debate The Perversity of Success in Asset Management Is Alpha Dead? 2

3 What Is Alpha? Difference in Returns Between The Investment Manager and the Benchmark or Index. Typical Benchmark for Canadian Equities is the S&P/TSX Total Return Index Active vs Passive Investment Management Debate, i.e. Can You Beat The Market? Alpha is Also Known As: Value Added Excess Return 3

4 Beating the Market Has Become Nearly Impossible OBITUARIES Alpha is Dead 4 Source: Institutional Investor, Julie Segal, Oct ; The Death of Alpha On Wall Street, Scott Appleby, Tabb Forum, December 23, 2013

5 Who Are The Culprits In the Death of Alpha? Consultants Too Quick to Replace Managers Investment Committees Weak Governance, Spending Majority of Time On Non-Governance Matters (i.e. Economy, Performance, etc) Financial Innovation ETFs Are Commoditizing Alpha Money Managers Overpromise Performance & Over Simplify Process Pension Staff Inexperience Leads To Chasing Hot Performing Managers Private Equity Firms Reduce # of Stocks By Taking Companies Private Regulators & Accountants Regulation Fair Disclosure* Sell Side (i.e. Brokers) HFT Trading Costs Dramatically Lower Technology The Internet Information is Immediately Disseminated Each Participant Knows That It Is Working Conscientiously, Knows it is Working Hard, and Believes Sincerely In Its Own Innocence. 1 5 *Regulation FD All publicly traded companies must disclose all material info to all clients at the same time, Aug Charles Ellis., Murder on the Orient Express: The Mystery of Underperformance., (July/August 2012), Financial Analysts Journal, Vol. 68, No. 4. pp: 7. See as well Death of Alpha On Wall Street by Scott Appleby, Dec 2013, Tabb Forum.

6 Is Active Investment Management Dead? Not A New Concept US Active Managers Confounded Makan, Ajay, McCrum, Dan and Mackenzie, Michael., Start Stock Pickers Struggle to Beat Index. (Nov 2011). Financial Times. Available Online. 2 AAA Staff., Stock-Picking Alpha in a Life or Death Struggle. (Oct 2010). All About Alpha. Available Online. 3 Bianco Research L.L.C. Why 2011 Was a bad Year for Money Managers. (Jan 2011). [Conference Call Handout] 4 Goodman, Beverly. Meet the New Math, Same as the Old Man. (Mar 2012). Barrons. Available Online. 5 Cooper, Jay., Rogercasey Defends Active Managers. (Sept 2009). FundFire.com. Available Online. 6 Fay, Sharon., Is Active Management Dead?, (Oct 2011). Allinace Bernstein Blog. Available Online. 7 Flood, Chris. US Active Managers Confounded by Correlations., (Jan 2012). Financial Times. Available Online. 8 Lauricella, Tom and Zuckerman, Gregory. Macro Forces in Market Confound Stock Pickers. (Sept 2010). The Wall Street Journal. Available Online.

7 Active Investment Management Success Varies Over Time 7 Source: Peak Passive: The Coming Active Renaissance, by Joe Mezrich, Nomura Quant Strategy, Jan 5, 2017

8 Three Fundamental Laws Driving The Active/Passive Debate Three Fundamental Laws Driving The Active/Passive Investment Management Debate 1.The Market Is Driven By Different Factors Over Time 2. Arithmetic Of Active Investment Management 3. The Fundamental Law of Active Investment Management 8

9 The Market Is Driven By Different Factors Over Time In the Short Term, Many Factors Can Drive Market Returns and Influence The Success Of Active Management Irrespective Of Skill: Beta Cap Commodities Currencies Fiscal Policy Fundamentals Interest Rates Monetary Policy Noise Politics Risk or Volatility Speculative Style Etc 9.

10 Quarterly Excess Return Cap Managers Tend to Outperform 20% 15% 10% 5% 0% -5% -10% Small Cap Outperforms Large Cap Outperforms Russell 2000 TRI - S&P 500 TRI Quarterly, Mar 1980 Dec 2016 Statistics Qtrl. 1 Year Rolling Mean 0.1% -0.3% Median -0.4% -1.0% Stdev 5.2% 11.7% High 15.1% 41.5% Low -15.4% -34.7% -15% % 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% 1 Year Rolling Excess Return Quarterly Excess Return 1 Year Rolling Excess Return 10 Sources: See Footnote 1.

11 Risk: Active Management Underperforms When High Risk Wins Rolling 3 Month Return Spread Between High & Low Risk Stocks Stocks from the S&P/TSX Composite Jan 1986 Dec % 60% 40% 20% Statistics Mean -3.5% Median -3.5% StDev 14.9% High 62.9% Low -46.5% 80% 60% 40% 20% 0% 0% -20% -20% -40% -40% -60% -60% Standard Deviation 30 days 11 Risk is measured as 30 Day Standard Deviation of Returns, Top 30 and bottom 30 stocks, 3 Month Rolling Data, Monthly Rebalanced Sources: See Footnote 1.

12 In High Risk Regimes, Stock Correlations Are High and Stock Dispersion is Low Russell Day Intra-Portfolio Correlation vs VIX Monthly, Dec 1986 Dec Month IPC IPC Statistics Mean 0.28 Median 0.26 Stdev 0.12 High 0.66 Low 0.07 VIX Statistics Mean Median Stdev 7.97 High Low 9.82 Dec-16 IPC: 0.18 VIX: Month Ending VIX Recession Periods and Bear Markets IPC Average VIX VIX Erb, Claude B., Harvey, Campbell R., and Viskanta, Tadas E., Forecasting International Equity Correlations (November/December 1994), Financial Analysts Journal, Pages 32 45; Campbell, Rachel, Koedijk, Kees, and Kofman, Paul., Increased Correlation in Bear Markets (January/February 2002). AIMR, Pages Bouchaud; Jean-Philippe, and Potters, Marc., More Stylized Facts of Financial Markets: Leverage Effect and Downside Correlations (2001). Physica A, Pages 60-70; Pownall, Rachel A.J., Forbes, Catherine S., Koedijk, Kees C. G. and Kofman, Paul, Diversification Meltdown or Just Fat Tails? (June 2006), EFA 2006 Zurich Meetings; Ankrim, Ernest M., and Ding, Zhuaxin., Cross-Sectional Volatility and Return Dispersion (September/October 2002), AIMR, Pages 67-73;Weigand, Robert A., Gorman, Larry R. and Sapra, Steven G., The Cross-Sectional Dispersion of Stock Returns, Alpha and the Information Ratio (Fall, 2010), Journal of Investing; Bouchey, Paul., Fjelstad, Mary. and Vadlamudi, Hemambara., Measuring Alpha Potential in the Market (2011). Journal of Investing. Fall 2011, Vol. 2, No. 2: Pages

13 This Law Will Help You Avoid The Performance Trap The Performance Trap: Selling This Year s Loser Which Becomes Next Year s Winner and Buying Last Year s Winner Which Becomes this Year s Loser 13 Source: Perspectives on Institutional Investment Management, by Harry S. Marmer, Rogers Publishing, 2002

14 Active Investment Management Is Usually Called Into Question At Precisely The Wrong Time RBC Dexia Median Canadian Equity Manager vs. S&P/TSX TRI Yearly, % 9% 8% 7% 8% 7% 6% 5% 6% 5% 4% 3% 2% 1% % 3% 2% 1% 0% -1% 0% -1% -2% -3% -2% -3% -4% -5% % -5% Calendar Year Value Added 4 Year Annualized 14 * Data Source: SEI and RBC Dexia. As of December 31, * Source: In Defense of Active Investment Management, by Chris Thompson, Rogerscasey, September, 2009

15 2. The Arithmetic of Active Investment Management Part A. Market (Index) Return = Passive Portfolios + Active Portfolios In A Perfect or Efficient Market, The Average or Median Manager Will Approximate the Market or Index Return Before Costs 15 Source: The Arithmetic of Active Management: Does Fund Size Matter? Reprinted with permission from The Financial Analysts' Journal Vol. 47, No. 1, by William Sharpe, January/February pp Before Costs The Return On The Average Actively Managed Dollar Will Equal The Return On the Average Passively Managed Dollar.

16 In A Perfect World or Efficient Market, The Median Manager Will Approximate the Index Return Before Costs US Equities 5 Year Annualized Return Ending Dec % 16% 1 st Quartile 14% 12% 3 rd Quartile Median Manager S&P % US Equity Universe 1 st Quartile Median rd Quartile S&P Source: Mercer Pooled Fund Survey, December 2013.

17 2. The Arithmetic of Active Investment Management Part B. Market Return Passive Portfolios + Active Portfolios In An Imperfect or Inefficient Market, The Average or Median Manager Will Not Approximate the Market or Index Return Before Costs 17 Source Harry Marmer, The Active vs Passive Debate, Before Costs The Return On The Average Actively Managed Dollar Will Not Equal The Return On the Average Passively Managed Dollar.

18 How The Arithmetic of Active Investment Management May Not Add Up Not All Active Portfolios Are Tracked 1 Skewed Index, i.e. Narrow, Concentrated Survivorship Bias 1 Active Management Tilts Are Rewarded Bubbles 18 1 This is discussed in more detail by Manager Selection, by Scott Stewart, Research Foundation of CFA Institute, 2013.

19 In An Imperfect or Inefficient World, The Median Manager Will Not Approximate the Market Canadian Small/SMID Cap Equities 5 Year Annualized Returns Ending Dec % 15.0% 12.0% 9.0% 6.0% 3.0% 0.0% Median Manager 5th Percentile 15.7% 1st Quartile 6.9% Median 5.2% 3rd Quartile 1.8% 95th Percentile -0.2% S&P/TSX Small Cap -5.7% -3.0% -6.0% TSX Small Cap Cdn Small/SMID Cap 19 Source: Mercer Pooled Fund Survey, December 2015.

20 What Is Skill? Key Characteristics of Successful Investment Managers Factor 1 Intelligence 2 Knowledge 3 Focus 4 Long-Term Thinking 5 Independent Thinking 6 Alignment of Interests 20 Source: Scott D. Steward. Manager Selection, (December 2013), Research Foundation of CFA Institute, Page 32.

21 Active Management Is Hard * *The Great Divide over Market Efficiency, 03 MAR Clifford Asness, John Liew, Institutional Investor, March 2014, The Great Divide Over Market Efficiency 21

22 Canadian Fixed Income: Easy or Hard To Beat? 4 Annual Excess Returns of 1st Quartile, Median and 3rd Quartile Managers vs. DEX Bond Universe (%) Annualized Since Inception* 0.1% Median Manager % of Managers 32% 64% 50% 66% 78% 24% 69% 28% 56% 53% 32% 71% 67% 55% 73% 48% 65% 55% 42% 53% 70% 26% 23% 89% 77% 20% 89% 79% 42% 48% 83% Outperforming st Quartile DEX Statistics Median DEX 3rd Quartile DEX Mean Median Stdev High Low Statistics % of Managers Outperforming Mean 56% Median 55% Stdev 20% High 89% Low 20% *Based on median manager returns. Source: Hillsdale Investment Management, Mercer Investment Consulting Pooled Fund Survey, $Cdn. As of Dec 31, Updated January 30, 2017.

23 Canadian Fixed Income: Very Hard To Beat Annual Excess Returns of 1st Quartile, Median and 3rd Quartile Managers vs. DEX Bond Universe (%) Annualized Since Inception* 0.1% Median % of Managers 32% Outperforming 64% 50% 66% 78% 24% 69% 28% 56% 53% 32% 71% 67% 55% 73% 48% 65% 55% 42% 41% 70% 13% 23% 89% 77% 20% 89% 79% 42% 48% 83% Statistics Statistics 1st Quartile 3rd Quartile % of Managers Median DEX Legend DEX DEX Outperforming Median Mean Mean 56% Median Stdev High Low Median 55% Stdev 20% High 89% Low 20% *Based on median manager returns. Source: Hillsdale Investment Management, Mercer Investment Consulting Pooled Fund Survey, $Cdn. As of Dec 31, Updated January 30, 2017.

24 Cdn Small Cap Equities: High Skill, Plenty of Opportunities Annual Excess Returns of 1st Quartile, Median and 3rd Quartile Managers vs. S&P/TSX Small Cap Index (%) Annualized Since Inception 4.4% Median S&P/TSX Small 2006 Cap % of Managers 88% 74% 100% 66% 44% 43% 79% 76% 33% 9% 78% 77% 73% 41% 78% 78% 77% 76% 66% 33% 23% 84% 94% 100% 88% 91% 6% Outperforming 24 Q Statistics S&P/TSX S&P/TSX Small Cap Small Cap Q S&P/TSX Small Cap Mean Median Stdev High Low *Based on median manager returns. Source: Hillsdale Investment Management, evestment Alliance. As of Dec 31, Updated February 1, Statistics % of Managers Outperforming Mean 66% Median 76% Stdev 27% High 100% Low 6%

25 Why Can Alpha Shrink Over Time? 1. Active Bets Diminish Over Time 2. Skills Are No Longer Skills 3. Increase in AUM i. Transaction Costs Creep Up ii. # of Securities Increase ii. Hire More Professionals Increase in Securities iii. Higher Administrative Stress iv. Deviation from Style 4. Lifecycle of A Business, i.e. Business Decisions No Skill Protective Mode, i.e. Guardian Mentality 25 Sources: Mutual Fund Performance: Does Fund Size Matter? Financial Analyst Journal, by Daniel C. Indro, Christine X. Jiang, Michael Y. Hu and Wyne Y. Lee, May 1999, The Evolution of Investment Processes, by Paul Greenwood, Russell Research Commentary, June 1999.

26 As AUM Increases, More Professionals Are Hired, More Administrative Care Is Required Number of CFA Charter Holders vs. Number of Stocks & Mutual Funds 180, , ,000 Exponential Growth 120, ,000 80,000 60,000 40,000 20, Listed Companies Mutual Funds CFA Charter Holders 26 Source of Data: CFA Institute, World Federation of Exchange

27 Key Takeaways Alpha (Value Added) Is Not Dead Any Assessment Of The Success of Active Management Should Always Consider: The Factors Driving Stock Returns The Benchmark Representing the Investment Opportunity Set The Odds of Beating The Market Both Active and Passive Investment Management Success Is Cyclical i.e. Go In And Out Of Favor Over Time The Dynamics Of Winning In Active Investment Management Vary Over Time. These Variabilities Reflect Both The Complexity and Dynamics Of The Market Significant Value Added Can Be Gained In Select Asset Classes But Success Will Depend on Manager Breadth, Skill and the Market To Temper the Quest for Mediocrity Clients Can Align Their Managers with Well Designed Incentive Based Fees 27 Source: Empirical Evidence Indicates a Positive Correlation Between the Inclusion of Performance Based Fees and Higher Alphas page 69 in Manager Selection by Scott Stewart, Research Foundation of the CFA Institute, 2013.

28 Appendix 28

29 Chasing Performance Law #1 Suggests That It is Very Challenging For Active Managers To Stay Consistently in First Quartile Managers in Top Quartile Year Of Past Performance Has NO Predictive Power 29 Source: Hillsdale Investment Management, evestment Alliance. Manager universe is based on evestment s All Canadian Equity Universe.

30 Institutional Managers Outperform Using a dataset of $17 trillion of assets under management, we document that actively managed institutional accounts outperformed strategy benchmarks by 86 (42) basis points gross (net) during In return, asset managers collected $162 billion in fees per year for managing 29% of world capital. We trace this outperformance to systematic deviations from the asset-class benchmarks. The asset manager industry is therefore not just a passive pass-through entity Source: Institutional Performance and Smart Betas by Joseph Gerakos Juhani T. Linnainmaa Adair Morse, November 28, 2016

31 We Find That the Average Mutual Fund Has Used This Skill to Generate About $3.2 Million Per Year. The total value the manager extracts from markets is equal to the amount of money the fund charges in fees, minus any money it takes from investors: the percentage fee multiplied by AUM plus the product of the return to investors in excess of the benchmark and AUM. This quantity is the fund s gross excess return over its benchmark multiplied by assets under management, what we term the value added of the fund. Investors appear to be able to identify talent and compensate it: current compensation predicts future performance. Not only do better funds collect higher aggregate fees, but current aggregate fees are a better predictor of future value added than past value added To measure skill we take the product of the fund s abnormal return (the return before fees minus the benchmark return) and assets under management (AUM) Source: Measuring Skill in the Mutual Fund Industry, by Jonathan Berk and J. van Binsbergen, Journal of Financial Economics, 2015, vol. 118, issue 1, pages

32 Harry S. Marmer Harry S. Marmer, BBA, MBA, CFA, Partner. Prior to joining Hillsdale in 2008, Mr. Marmer led the Canadian institutional business of Franklin Templeton Investments and before that the institutional business at Russell Investment Group. He was also a principal and co-leader of Mercer's Canadian Investment Consulting Practice. Before this he was a Senior Investment Analyst at Sun Life Canada. Mr. Marmer is a frequent conference speaker and has authored more than 49 articles and a book entitled, "Perspectives in Investment Management." Currently, he continues to volunteer for the CFA Institute and is a member of the Investment Committee of the Canadian Friends of Hebrew University. Mr Marmer has served on a number of industry boards and was past president of the Toronto CFA Society. He was awarded the Toronto CFA Society s Research Award and received the Society s Volunteer of Distinction Award 32