All investors have to make a choice to embrace either a passive or active strategy when selecting investments. Passive strategies attempt to capture the market’s return, while active strategies attempt to outperform it. Gains that active managers earn above the stock market’s return are commonly referred to as alpha. Before investors pursue alpha, they should evaluate the probability of capturing it and, if captured, whether value can be added net of expenses and taxes.
Numerous studies have confirmed the vast majority of mutual funds do not deliver alpha net of expenses (e.g., Elton (1993), Carhart (1997)). More recent studies have shown up to 25% actually generated negative alpha1. In other words, the manager’s stock picks have actually destroyed value and detracted from performance. Worse yet, for those still compelled to pursue alpha, it should also be noted that negative alpha (i.e., underperformance) is on average greater than positive alpha.
The table below shows the amount of alpha generated by percentile in 2011:
Investors holding multiple actively managed funds as part of a diversified portfolio are not only likely to have more funds generating negative alpha than positive alpha, but any positive alpha achieved is likely to be offset by significant negative alpha in another. This imbalance will likely cause poor overall portfolio returns.
Attempting to generate alpha is an expensive process; it’s both data and time intensive, requiring a significant investment in both technology and manpower. To cover these higher costs, funds pursuing alpha almost always come with higher operating expenses relative to the passively managed funds. The table below lists the average net operating expense ratio of the two strategies.
In an efficient market where prices quickly react to new information, overcoming a 0.71% hurdle in additional expenses is no small task and a significant reason why actively managed portfolios often underperform their passive benchmark.
Actively managed strategies attempt to add value by continuously putting their best ideas to work in the portfolio. This inevitably increases the portfolio’s turnover ratio (i.e., amount of trading), which not only increases hard dollar costs such as commissions, but also generates realized gains in the portfolio. Capital gains incurred in this manner are frequently realized earlier and are often subject to higher ordinary income rates.
The amount of return lost due to taxes on distributions can be measured using the Tax Cost Ratio. It assumes taxes are paid at the Federal level and at the highest tax bracket. For example, the table below shows the Tax Cost Ratio for a large sample of actively managed large cap funds vs. the widely held Vanguard S&P 500 index fund over the past five years:
The table shows the Vanguard S&P 500 not only has a lower turnover, it also is considerably more tax-efficient, giving up less than half as much to taxes as its active peers did.
Considering the low success rate of capturing alpha, the higher likelihood of capturing a significant amount of underperformance, and the greater costs associated with these strategies net of fees and taxes, it is highly probable that investors would benefit from embracing a low-cost, low-turnover, passive alternative as the cornerstone for their investment philosophy.
1Barras, Scaillet, Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” The Journal of Finance, February 2010.
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