Growth in indexing spells outperformance
Fund industry researcher Professor Russ Wermers at the University of Maryland discusses managers’ alpha, price pressure and the benefits of indexing for active managers.
Professor Wermers, you have been researching the mutual fund industry for the past 15 years. Is it possible to identify true alpha, truly skilful managers?
There was a structural shift in the mid-1990s. Before that, we found that 14% of managers were able to outperform their fees sustainably, giving investors alpha for the trailing five-year periods we looked at in a paper for The Journal of Finance in 2010.
This number diminished to nearly zero until 2006. Our conclusion is that active management skills have deteriorated seriously over our sample period.
It’s not that they have turned negative, but 75% of those guys deliver performance that is on par with an index fund after fees.
Why is that? Are sell-side companies such as investment banks attracting more talent?
We do not know exactly. But there are plausible signs for the talent thesis.
Research from the Massachusetts Institute of Technology indicates the best mutual fund managers tend to leave for the hedge fund industry.
But it could also do with competition, as ever more fund managers are competing for alpha.
The number of funds has increased much faster than the number of stocks has, for example.
Now you have a ton of managers trying to chase the same anomalies. But investors are increasingly using index funds to buy stocks.
Thus, the competition for alpha should decrease again.
Absolutely. If you look at stocks that have much index fund participation versus those that have very little, it turns out those that have a lot are being priced less efficiently.
So, active managers have more anomalies to benefit from. As indexing grows, we will come back to an equilibrium where more active managers can outperform net of fees.
It has to, because otherwise the active management industry cannot exist.
Do index funds exert price pressure on the active industry?
Yes, it has brought some price pressure on active funds. But not enough yet.
The good news is that trading costs are a fraction of what they were 20 or 30 years ago.
Many professional investors like pension funds have started to invest heavily in index funds. Do you see a trend here?
A real sea change happened after the crisis, because many people received fairly bad returns from their active managers.
Now there is a big buzz about passive making a big leap forward, at least in the US.
We have large-cap core stocks that are owned half by index funds.
But the area of large-cap stocks might be an exception, as we tend to see less value added by active management there.
For mid and small caps or value stocks we find still much less institutional ownership by index funds.
The Financial Stability Board and the Bank for International Settlements have warned about the systemic risk posed by exchange-traded funds (ETFs). Does this sound reasonable?
The industry is creating all of these focused strategies, on single themes and sectors, and at the same time building ‘active’ ETFs.
This could easily exacerbate volatility. There is also concern about how all of those newly created active ETFs will deal with liquidity. Index funds, like active managers, need to buy and sell according to their fund flows.
Active ETFs have to worry about this too, but in a different way. Often the index funds need liquidity because they are forced to sell, because they are judged by their tracking error, when active managers can be more patient.
But many investors are aware of the shortcomings of investing passively into an index. Is fundamental indexing a solution?
For me, this is a camouflaged active strategy. I would be uncomfortable to say that this is the way to go. It exposes a lot of people to a similar strategy, chasing value and smaller-cap stocks.
Like with the hedge fund industry, this might create commonality in strategy.
Hedge funds got in trouble in 2007 because there was commonality in strategy, not because they were leveraged too high.
If you have ETFs doing the same thing and investors flocking to certain fetish markets, this could definitely create systemic risk.
Fundamental indexing, marketed heavily as an alternative to market cap indexing, could generate dislocations in the market.
Russ R. Wermers is associate professor of finance at the Robert H Smith School of Business at the University of Maryland.
In 2010 he published the paper ‘False Discoveries in Mutual Fund Performance:Measuring Luck in Estimated Alphas’ in The Journal of Finance.
His current research areas include the impact of mutual funds on stock markets and empirical tests of the efficiency of stock markets.