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It Is Getting More and More Difficult to Generate Alpha, Especially After Taxes

Larry Swedroe Mar 02, 2016

The Incredible Shrinking Alpha

  • Academic research has been converting what was once alpha into beta (a common factor easily accessed through low-cost, passively managed funds).
  • The supply of sheep (victims) available to be sheared (exploited) by active mutual fund managers has been persistently shrinking as the percentage of the total market owned directly by individuals (the sheep) has fallen dramatically over the past 70 years.
  • The skill level of the competition engaged in pursuing alpha has greatly increased.
  • The amount of capital chasing this reduced supply of alpha has greatly increased as well.

Now, thanks to a recent study by Jeffrey Ptak, Morningstar’s director of global manager research, we possess further evidence that the likelihood of generating alpha not only has been declining, it’s collapsing. Consider the following.

In his new study, presented in the February/March 2016 issue of Morningstar magazine, Ptak set out to determine how many U.S. equity funds went on to beat their relevant index fund benchmark on an after-tax basis over the 10-year period ending October 2015.

Ptak, who assumes that the investor sells at the end of the period, found that out of the 4,993 funds he studied, only 205 beat their benchmark index fund on an after-tax basis. That’s just 4.1%. On a relative basis, 70% fewer funds outperformed on an after-tax basis than Arnott, Berkin and Ye found to be the case in their study, done just 15 years earlier. And what’s more, 10% fewer did so on an absolute basis.

Ptak also found that it didn’t matter which asset class he looked at; only a very small percentage of active funds outperformed on an after-tax basis. Keep this in mind the next time you hear arguments about active management outperforming in supposedly inefficient asset classes (such as small-cap stocks).

The Bottom Line

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