Less Efficient Markets = Higher Alpha?


Students often ask me for career advice. It’s not a particularly satisfying experience. For one thing, they are often exceptionally bright and hard-working people with PhDs from Oxford or Cambridge in chemical engineering, astrophysics or some other challenging discipline. Hopefully they’ll stick to science and create something meaningful for our civilization instead of trying to generate a few extra base points per year.

On the other hand, some students decided early on to pursue a career in finance and studied accordingly. Telling them to build better fertilizers or rockets doesn’t make much sense. But professional financial advice is increasingly difficult to provide. Because? Because global capital markets are already very efficient and every day machines are taking more and more market share from humans. The career prospects for someone with a master’s degree in finance and some basic Excel skills are steadily diminishing.

Subscribe button

Of course, it depends on the role. Most students dream of becoming fund managers and managing money. Exchange-traded funds (ETFs) have become their main competitors. So if fund management is the career aspiration, perhaps focusing on less efficient markets, whether niche private or equity, is smart career advice.

After all, fund managers should theoretically be able to extract more alpha from these markets. Of course, in the world of investing, reality often departs substantially from theory. So how have fund managers fared in less efficient stock markets?

Alpha Generation in US Stock Markets

To answer this, we first investigated the ability of fund managers to create alpha in US stock markets. S&P’s SPIVA dashboards provide great insight into the performance of mutual fund managers.

They paint a pretty depressing picture: 82% of US large-cap mutual fund managers failed to beat their benchmark over the 10 years between 2010 and 2020. Between 2000 and 2020, a an astonishing 94% did not make it.

Given that the constituents of the S&P 500 are the most traded and researched stocks on earth, this is perhaps to be expected. However, US small-cap fund managers didn’t fare much better: 76% underperformed their benchmark over the past 10 years, despite all the hidden gems.

Most capital allocators assume that specialized knowledge has value. Real estate equities (REITs) are somewhat unusual instruments in that they have characteristics of stocks, bonds and real estate. In theory, these sectors should offer rich alpha opportunities for dedicated fund managers. Unfortunately, even these markets are too efficient in the United States. More than three in four REIT fund managers, 76%, failed to beat their benchmarks.

US Equity Mutual Funds: Percentage Underperforming Their Benchmarks

Chart showing US equity mutual funds: percentage underperforming their benchmarks
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Exploiting less efficient markets

Compared to their US counterparts, emerging markets are less regulated and company data is not always equally disseminated. Information asymmetries are significantly higher and many markets, including China, are dominated by retail investors. Overall, this should enable sophisticated fund managers to create substantial value for their investors.

But when we compare equity mutual fund managers in developed and emerging markets, both fared poorly. Of developed market fund managers, 74% underperformed their benchmarks in the three years ending 2020, compared with 73% of emerging market fund managers.

Equity funds have underperformed their benchmarks over the past three years

Chart showing equity funds that have underperformed their benchmarks over the past three years
Source: S&P SPIVA Scorecards 2020, FactorResearch

While investors tend to select mutual funds based on three-year performance data, that’s a relatively short period and may not include a full boom-and-bust market cycle. Perhaps fund managers need more time to demonstrate their acumen and should be evaluated over longer time horizons.

Unfortunately, extending the observation period does not improve the outlook. Emerging market mutual fund managers performed slightly worse than their developed market counterparts. Over the past five years, 84% underperformed their benchmarks, compared with 80% of developed market fund managers. And over the past 10 years, 85% underperformed emerging markets versus 82% of their developed market peers.

Equity funds underperform their benchmarks: developed markets and emerging markets

Chart showing equity funds underperforming their benchmarks: developed and emerging markets
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Performance consistency

To be fair, mutual fund managers’ lack of alpha generation is nothing new. Academic research has marked this for decades. Capital allocators stress that it’s all about identifying the few funds that generate consistent excess returns. This is an interesting point to evaluate in emerging markets. Fund managers should have more opportunities to gain a competitive advantage given the higher information asymmetries compared to developed markets.

S&P also provides data on performance consistency – it paints a truly dismal picture for US equity mutual funds. For example, only 3% of the top 25% of funds in 2016 managed to stay in the top quartile the following year. Over a four-year period, less than 1% did. Put differently, there is no performance consistency.

In contrast, emerging markets show some consistency in performance the following year. A random distribution would assume that 25% of funds in the top quartile can hold their position, and a higher percentage of funds would achieve that in Brazil, Chile and Mexico.

In subsequent years, however, this percentage falls, showing that almost no fund shows consistency in performance. The best-performing mutual funds seem to lack a competitive edge in the stock markets.

Performance Consistency: Percentage of funds in the top quartile in 2016 that remain in the top quartile

Chart Showing Performance Consistency: Percentage of Top Quartile Funds in 2016 Remaining in Top Quartile
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Emerging markets hedge fund

Most emerging market mutual fund managers failed to outperform, and the few that did were more lucky than skilled given the lack of consistency. Perhaps being limited to a pool of stocks in a benchmark is not conducive to alpha generation.

So what if we evaluate the performance of emerging market hedge funds that are relatively unconstrained? General market conditions should not matter as these funds can be long and short stocks, bonds and currencies.

But even these highly sophisticated investors have struggled to beat their benchmarks. The HFRX EM Composite Index shared the same performance trends as the MSCI Emerging Market Index, albeit with reduced volatility. The return has been essentially zero since 2012, except for a spike in 2020 reflecting the rebound in stocks from COVID-19, which indicates beta rather than alpha.

Emerging market hedge funds vs. variable income and bonds

Chart showing emerging market hedge funds vs.  stocks and bonds
Sources: HFRX, FactorResearch

Additional thoughts

Emerging markets are less efficient capital markets with larger information asymmetries than developed markets. Microsoft is covered by more than 30 Wall Street research analysts and Amazon by more than 40. No emerging market stock is scrutinized the same way, and most lack institutional research coverage.

So why can’t emerging market mutual fund managers take advantage?

Tile for Future of Work in Investment Management: Report 2021

Management fees reduce alpha, of course, but the main reason is that stock picking is just plain hard, regardless of the market. There may be more alpha opportunities in emerging markets, but there is also more risk. Argentina managed to get away with selling a 100-year bond in 2017, and Mozambique issued bonds to finance its tuna fleet in 2016. Neither country is likely to manage that today. Fortunes change quickly in emerging markets where stability is less assured, making forecasts useless.

This means that focusing on less efficient stock markets is not a particularly sound career move, at least for those seeking fund management. Perhaps the smartest advice is to simply follow the money, which is pouring into private markets like private equity and venture capital. These are complicated asset classes that are difficult to compare and calculate whether the products offer value. Complexity may be an investor’s enemy, but it is asset management’s friend.

For more information from Nicolas Rabener and the FactorResearch team, sign up for their email newsletter.

If you liked this post, don’t forget to subscribe to Entrepreneurial investor.

All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / Mats Anda

Professional training for CFA Institute members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Entrepreneurial investor. Members can easily register credits using their online PL tracker.

Nicholas Rabener

Nicolas Rabener is the CEO of FactorResearch, which provides quantitative solutions for factor investing. He previously founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focusing on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabener holds a master’s degree in management from the HHL Leipzig Graduate School of Management, holds the CAIA charter and enjoys endurance sports (100 km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

Source link

Leave a Reply

Your email address will not be published. Required fields are marked *