By |Published On: November 18th, 2022|Categories: Larry Swedroe, Research Insights, Behavioral Finance|

The empirical research on the ability of actively managed funds, including such studies as the  2002 paper “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses” by Russ Wermers, has found that they do have the ability to identify stocks that go on to outperform appropriate benchmarks—they are skilled. But are active managers victims of the same bias as individual investors? That is the question we’ll explore in this paper.

Gross Alpha – A Zero Sum Game

Unfortunately, that same empirical research has found that the gross alpha (risk-adjusted outperformance) generated has not been sufficient to offset active managers’ implementation costs, which include not only the fund’s expense ratio but its trading costs and the drag from holding cash—their net alphas (the only kind investors care about) are negative. Of course, since generating even gross alpha is a zero-sum game (generating net alpha is a negative-sum game due to costs), there must be losers. And the losers, as a series of studies by Brad Barber and Terrance Odean have demonstrated (for example, here), have been retail investors—the stocks they buy go on to underperform, and the stocks they sell go on to outperform. 

New Research

There’s an interesting new paper on the subject of active managers and their ability to generate alpha by Chris Woodcock, Alesi Rowland and Snežana Pejić, “The Alpha Life Cycle: New Insight into Investment Alpha and How Portfolio Managers Can Sustain It,” published in the October 2022 issue of The Journal of Investing. Excluding positions held for less than 20 days, they examined 9,254 episodes (full cycles of a given position from first entry to last exit) across 43 active equity portfolios of Essentia Analytics over 2005-2019. Following is a summary of their findings: The vast majority of episodes (85.54 percent) were less than 500 business days long, and the average entry-to-exit episode was just under a year (257 business days).

Frequency of Different Episode Lengths within the Data Set

Frequency of Different Episode Lengths within the Data Set
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.
  • Excess return attributable to manager decision-making at the position level (e.g., timing, sizing, scaling) has a distinct and persistent life cycle, tending to accumulate in the early phase of an investment and decay over time—often precipitously.
  • The average episode’s alpha trajectory (as measured by cumulative excess return on investment, or ROI, over the nominated index of the portfolio) followed an inverted horseshoe pattern and finished with a loss of over 2 percent—on average, positions were held too long.

Grand Mean of Cumulative Relative ROI Over All Episodes

Grand Mean of Cumulative Relative ROI Over All Episodes
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.
  • There was a progressive rise in cumulative return on investment (the curve is in its top quartile for about six months and above 50 percent for about nine months) followed by a steep decline before exit, with the mean overall impact of each full episode marginally negative; the drop from the peak to exit was 7.22 basis points.

Grand Mean Cumulative ROI for All Episodes Relative to the Percentage Through Episode

Grand Mean Cumulative ROI for All Episodes Relative to the Percentage Through Episode
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Citing research from the field of behavioral finance, Woodcock, Rowland and Pejić hypothesized that holding positions too long could be explained by the well-documented bias of the endowment effect—the tendency to place greater value on something already owned, often considered as a manifestation of loss aversion, a component predicted by prospect theory. They explained that once an investor holds an appreciating stock, “the investor imbues that stock with positive attributes. Once the stock appreciation begins to deteriorate or plateau and the investor is considering a sell, a higher value is given to longstanding positive views of the stock, leading the investor to hold the security while sacrificing previous positive contributions to alpha.”

Their hypothesis is consistent with the findings of Mengqiao Du, Alexandra Niessen-Ruenzi, and Terrance Odean, authors of the 2018 study “Stock Repurchasing Bias of Mutual Funds,” and Mehran Azimi, author of the 2019 study “Are Professional Investors Prone to Behavioral Biases? Evidence from Mutual Fund Managers,” who found that professional investors suffer from behavioral biases (such as overconfidence, political bias and home country bias), that their market outlook affects their risk-taking and asset allocation, and that fund managers’ optimism is detrimental to fund investors.

Conclusion: Are active managers biased the same way as individual investors?

The first takeaway should be that active investors appear to be subject to the same biases, including the endowment effect, as are individual investors—biases that negatively impact their performance. Systematic funds (such as, but not limited to, index funds) have the advantage of not having any human biases that can negatively impact their performance.

While the evidence we reviewed showed that while the active funds held their positions too long, cutting their holding period would lead to increased costs due to higher turnover. That higher turnover could be a significant negative in smaller stocks, with their higher bid-offer spreads, and greater market impact costs in addition to decreasing tax efficiency for taxable investors—potentially the incremental costs could exceed any benefits.

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About the Author: Larry Swedroe

Larry Swedroe
As Chief Research Officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, Larry Swedroe spends his time, talent and energy educating investors on the benefits of evidence-based investing with enthusiasm few can match. Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books: “What Wall Street Doesn’t Want You to Know” (2001), “Rational Investing in Irrational Times” (2002), “The Successful Investor Today” (2003), “Wise Investing Made Simple” (2007), “Wise Investing Made Simpler” (2010), “The Quest for Alpha” (2011) and “Think, Act, and Invest Like Warren Buffett” (2012). He has also co-authored eight books about investing. His latest work, “Your Complete Guide to a Successful and Secure Retirement was co-authored with Kevin Grogan and published in January 2019. In his role as chief research officer and as a member of Buckingham’s Investment Policy Committee, Larry, who joined the firm in 1996, regularly reviews the findings published in dozens of peer-reviewed financial journals, evaluates the outcomes and uses the result to inform the organization’s formal investment strategy recommendations. He has had his own articles published in the Journal of Accountancy, Journal of Investing, AAII Journal, Personal Financial Planning Monthly, Journal of Indexing, and The Journal of Portfolio Management. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN, and Bloomberg Personal Finance. Larry is a prolific writer and contributes regularly to multiple outlets, including Advisor Perspective, Evidence Based Investing, and Alpha Architect. Before joining Buckingham Wealth Partners, Larry was vice chairman of Prudential Home Mortgage. He has held positions at Citicorp as senior vice president and regional treasurer, responsible for treasury, foreign exchange and investment banking activities, including risk management strategies. Larry holds an MBA in finance and investment from New York University and a bachelor’s degree in finance from Baruch College in New York.