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Expert Analysis and Commentary
Larry Swedroe Oct 19, 2016
At least in theory, when assessing an active mutual fund manager’s skill, investors should consider all factors that explain the cross-sectional variations in fund performance. The academic literature has identified a small list of factors able to explain the vast majority of the variation in returns of diversified portfolios: market beta, size, value, momentum, profitability and investment.
The authors investigated whether investors tend to consider commonly used equity factors when assessing fund managers. In other words, do investors attempting to identify a skilled active manager strip out returns that can be traced to a fund’s exposure to investment factors known to explain cross-sectional equity returns? Fund flows should only respond to alpha, and not what is simply beta (loading on, or exposure to, a factor).
Their sample period covered the period from 1996 to 2011 and included about 4,000 equity funds. The following is a summary of the authors’ findings:
Barber, Huang and Odean concluded: “Our empirical analysis has revealed that investors behave as if they are concerned about market risk, but are largely unaware of other factors that drive equity returns. We have found some evidence that investors attend to the value, size, and industry tilts of a fund when assessing managerial skill, but these effects are much weaker than those we observed for a fund’s beta. Moreover, we have found that investors strongly respond to the factor-related return associated with a fund’s Morningstar-style category. Since the category-level return is not under the control of the manager, this result suggests some mutual fund investors confuse a fund’s category-level performance and manager skill.”
They also found that “the flows of investors who are likely more sophisticated – direct-sold fund investors, investors trading during low-sentiment periods, and wealthier investors – are generally less responsive to factor-related returns, suggesting that they are more aware that those returns are not indicative of the skills of the fund manager.”
Finally, the authors noted that to “adjust for factor-related returns when evaluating a fund, an investor needs to know the factor return. Sophisticated investors will seek out this information. But less sophisticated investors may not be aware of size, value, momentum, or industry returns. The market’s performance, however, is ubiquitously reported. This may be one reason why investors do pay attention to market risk when evaluating mutual fund managers.”
Clearly, choosing to invest in actively managed mutual funds is playing a loser’s game; it’s one that’s possible to win, but the odds of doing so are so poor that it’s imprudent to try. If you are going to try and play that game anyway (by investing in managers that you believe have outperformed in the past, defying the evidence and the SEC’s warning that past outperformance isn’t predictive of future outperformance) at the very least you should know if the fund has been generating true risk-adjusted alpha, or whether its market-beating returns are simply a result of its exposure to other factors (such as size and value) that can be obtained more cheaply with passively managed funds.
Fortunately, today investors can determine the risk-adjusted alpha of any fund, whether active or passive, simply by using the multi-factor regression tool available for free on Portfolio Visualizer.
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