The incredible shrinking ‘alpha’
Over the past ten years, a top quartile South African general equity fund has outperformed its peers by 1.6% per annum (p.a.). Top quartile balanced funds outperformed their peers by 1% p.a. Of course, if you were fortunate or skilful enough to have selected top decile performers, these differences would be materially higher; but such outperformance is sadly only available to about 10% of investors.
Five years ago, the universe of equity funds that had a ten-year track record was only half the size of the universe today, and the magnitude of outperformance was higher at 2% p.a. Ten years ago, the universe was half as large again, and the magnitude of outperformance was even higher at 2.6% p.a. This is not surprising: as the fund universe increases, investors should expect top quartile ‘alpha’ to decrease due to greater performance convergence amongst the middling funds. The chart below highlights that the top quartile premium for the domestic equity funds has reduced by 1% p.a. to the current level of 1.6% p.a. over the period of the analysis.
Increasing funds universe and decreasing alpha is a global trend
A similar trend is present internationally, where the fund universe is far larger, but has also grown tremendously over the past ten years. As shown in Chart 2, the ‘top quartile’ premium for the global equity funds has reduced from 1.7% p.a. in 2004, to the current level of 1.2% p.a. for the ten years ending August 2014.
Is this still worth fighting for?
The important question that this analysis elicits is: ‘Are we as fund selectors putting in all the research and effort to stake a claim on a paltry 1% or 2% p.a. which is potentially decreasing?’ Like any good question, the answer is a resounding: ‘it depends!’ Firstly, 1% or 2% p.a. compounds to something more meaningful over time. Secondly, and perhaps more importantly, by working hard to pick winners, we are improving our odds of avoiding the losers. Chart 3 highlights that the difference between top and bottom quartile equity funds has been in the region of 3.3% p.a. for South African equity funds and 2.4% p.a. for global equity funds; a far more material number when compounded over a ten year measurement period. But importantly the degree of outperformance of top quartile funds over bottom quartile funds has also been decreasing consistently.
[Note: there may be an important caveat emerging due to the rise of indexation. There are now fewer excuses for delivering below average performance for clients as index funds should provide at least average results with a high degree of predictability].
How do we ensure our share of the prize?
Given that evidence suggests that the magnitude of alpha is potentially decreasing for fund investors, what do we need to do to ensure our share of the prize? Firstly, I believe that fund investors need to be aware that fund providers operate in a highly competitive environment. Managers know exactly what we want to hear and see in our due diligence interactions. Almost all managers have convincing processes and philosophies and if you are considering them, they probably have a reasonable track record too. Most of these things are merely hygiene factors, not differentiators. Don’t get stuck on the track record part. Rather spend your time trying to figure out if the track record is worth paying any attention to at all. Ask the question: ‘Are the same people doing the same thing under the same conditions?’ More often than not, the answer is ‘no’, and the best course of action may be to discard the track record altogether.
Look for differentiators and genuine alignment of interests. Do the managers own their firm? Are they investing materially in the same funds as their clients? Are they paying the same fees? If not, why not: aren’t the fees fair? Is the manager permitted to invest in securities outside of the funds they manage? Why? Should they not be sharing their best ideas with clients?
Another critical part of the analysis should be to assess whether the managers are well adapted to the highly concentrated South African equity market structure. In such markets, errors of omission can be as important as errors of commission. So there is less room to take the Charlie Munger approach of just putting things on the ‘too hard pile’. It is perhaps in these ‘harder to understand’ companies that the most potential alpha exists, because fewer people may be looking at them. The best fund managers operate in a world of multiple potential outcomes and are able to manage risk at a portfolio rather than just at individual security level. They are able to construct portfolios that will produce reasonable returns in most scenarios rather than those that will produce excellent (or dire) returns in any particular scenario.
Has your manager made investments their career or their life? In other words, if they didn’t manage money for others would they still be as engaged in the market and manage money for themselves and their family or friends? These ‘market-animals’ may occasionally be odd-balls, but because alpha is a zero-sum game, it is those managers that are highly engaged and see things differently that are most likely to extract their piece of the pie from the competition.
Be careful of costs, tax and poor switching decisions
In a world of shrinking alpha we need to work harder to get our fair share. But we may also need to supplement ‘performance’ alpha by focusing on reducing investor costs, taxes and the impact of behavioural penalties. Be fee sensitive. Manage your clients’ wealth as tax efficiently as possible. Ensure that clients do not take on too little equity exposure and guarantee themselves poor absolute returns. There is a vast amount of research that suggests that investors switching from (temporarily) underperforming funds to (temporarily) outperforming funds can destroy more performance than investors can reasonably expect to achieve by picking top quartile managers. Different studies have produced different results, but it seems the average investor loses well over 2% p.a. relative to the returns of the funds they are invested in due to poor switching decisions. These are massive numbers.