Use ‘real alpha’ and ‘exotic beta’ when considering active vs. passive management
The debate over the virtues of active versus passive portfolio management probably will live forever.
The debate over the virtues of active versus passive portfolio management probably will live forever. Much of the debate boils down to ingrained theories related to the impact of fees on performance and the probabilities of active managers beating benchmarks in different market cycles.
On average, bear-market cycles tend to find active managers lagging their benchmarks — and suffering the consequences.
Last year, for example, when the Standard and Poor’s 500 stock index declined by 38%, actively managed stock mutual funds had net outflows of $222 billion, while index funds had net inflows of $17.6 billion.
FundQuest Inc., a $64 billion managed-accounts platform in Boston, has been studying the active-passive issue through calculations of what they call real alpha and exotic beta.
See the study here.
“There are different ways to measure an active manager’s value, but the simple way of just looking at investment returns compared to an index is the naïve way,” said Jane Li, an analyst at the firm.
Looking at traditional alpha, which measures an investment’s relative performance compared with a broad market index, is the first mistake in evaluating active managers, according to Ms. Li. “Any small-cap manager can outperform the S&P 500,” she said.
Real alpha eliminates the style bias by comparing performance with the most appropriate of 56 different benchmarks.
The analysis comes together by incorporating exotic beta, which is a concept borrowed from the hedge fund industry and refers to a premium associated with exposure to a particular asset class.
As opposed to traditional beta, which measures risk compared to the overall market, exotic beta measures the return derived from exposure to various systematic risk factors such as credit risk, liquidity risk and volatility risk that are common to a particular asset class, but not directly correlated to traditional stock or bond markets.
According to Ms. Li, these risk premiums vary by investment category. For example, investments in an international-bond-fund category may provide a specific risk premium owing to a lack of liquidity, political instability or currency changes.
In applying real-alpha and exotic-beta measurements to more than 30,000 actively managed mutual funds in 60 different categories, Ms. Li found that any consideration of passive versus active management needs to dig down at least to the category level.
The research, which analyzed each mutual fund’s performance during 13 three-year rolling periods over the 15 years ending in December 2008, found 12 categories that generated positive real alpha in bear markets and 19 in bull markets.
Eight fund categories, including emerging-market bonds, foreign large-cap value and specialty natural resources, generated positive real alpha during both bull and bear markets.
“The choice of passive or active matters, but it depends on the category, and that’s why we’re against the broad-brush argument that it is one way or the other,” said Ms. Li, who has run this same analysis in each of the past three years and come up with similar results.
The passive versus active debate can be resolved on an individual fund category basis as long as performance is traced to manager-generated alpha or beta in the form of market risk.
Foreign small/mid-cap growth funds, for example, represent a category that favors active management based on a history of 75% to 100% of managers in the category outperforming their benchmark. The category’s positive real alpha is calculated at 4.1 during bull markets and -0.5 during bear markets.
On the other hand, a case could be made for using an index or exchange traded fund for an allocation to large-cap value, where just 25% to 49% of active managers beat their index.
During bull markets, the real alpha of large-cap-value managers was calculated as -1.2, and during bear markets the real alpha was 0.02.
The emerging-market-bond-funds category generated positive real alpha during both bull and bear markets.
Between 50% and 74% of emerging-market-bond managers beat their index with real alpha of 1.7 during bull markets and 2.9 during bear markets.
“Real alpha is hard to get, and it’s expensive,” Ms. Li said. “Beta is cheap and it’s easy to get.”
A new Investment Insights column appears every Monday on InvestmentNews.com. E-mail Jeff Benjamin at jbenjamin@ investmentnews.com.
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