False Discoveries of the Elusive Alpha
David Swensen’s quote addresses the time-honored, but ill-fated attempts that manager pickers employ to beat the market. Most often, they hire active fund managers, in whom they confidently place their trust to deliver above-benchmark returns or alpha that would mirror some recent past result.
The term “alpha” represents the difference between the return on an investment and the return which could have been achieved in an index fund with similar risk exposure, quantifying a fund manager’s skill. A recent study by Laurent Barras, Olivier Scaillet, and Russ Wermers investigates the lack of true alpha in the results of 2,076 open-end domestic equity mutual funds for the 32 years from January 1975 to December 2006.
The study “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” employs the use of t-statistic hypothesis testing and statistical data to compare funds’ relative performance, employing a “False Discovery Test” to avoid errors which commonly plague statistical analysis and mitigate the effects of false positive and negative results. Unlike many previous studies of mutual fund performance, this method allows for distinctions to be made between fund results based on luck and those based on skill.
The conclusions of the study decisively reveal the folly of chasing alpha. Using data which prevents survivorship biases and excludes funds with less than five years of performance history, and taking into account the large effects of active management fees, the study concludes that 99.4% of all fund managers failed to demonstrate true stock-picking ability.
In a July 2008 New York Times article titled “The Prescient Are Few,” journalist Mark Hulbert digs into the results of the landmark study and its implications as described by Prof. Russ Wermers who headed up the study: “The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives,” says Prof. Wermers--or as Hulbert puts it “just lucky.”
The chart below reveals the thin line of managers that have beaten the benchmark over time — “statistically indistinguishable from zero,” according to the study.
The study dovetails the findings of another seminal study: “The Selection and Termination of Investment Management Firms by Plan Sponsors.” This study reveals how governing boards of retirement plans, foundations and endowments frequently fall prey to manager picking consultants and the allure of past winners, hiring the hottest new fund managers only to fire them later because their past performance doesn’t persist in the subsequent periods. The study, conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University, reveals the negative impact of manager chasing and found that manager hiring and firing decisions made by consultants and board members of retirement plans, endowments, and foundations was a complete waste of money and the board members precious time. Their results demonstrate that during the ten-year period from 1994 through 2003, consultants and boards which based their fund manager hiring decisions on consistent above benchmark past performance were largely disappointed with subsequent index-like results. They often then fired their managers in favor of another recent top performer, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving optimal returns, the kind of returns that are available by simply buying, holding and rebalancing a passively managed portfolio of index funds that keeps costs low and controls risk.