Less efficient market = higher alpha?


Students often ask me for career advice. This is not a particularly satisfying experience. On the one hand, they are often exceptionally bright and hard-working people, at Oxford or Cambridge PhD in Chemical Engineering, Astrophysics or some other challenging discipline. I hope they stick to science and try to create something meaningful for our civilization rather than making some additional foundation points annually.

On the other hand, some students decided early on to pursue a career in finance and studied accordingly. It makes less sense to ask them to make better fertilizer or rocket ships. But it is getting harder and harder to provide financial career advice. Why? This is because the global capital markets are already highly efficient and every day machines are occupying more market share than people. Career prospects for postgraduate degrees in finance and some basic Excel skills are steadily declining.

Naturally, it depends on the role. Most students dream of becoming a fund manager and managing money. Exchange-traded funds (ETFs) have become their main competitors. So if the fund manager is aspiring for a career, perhaps focusing on less efficient markets, personal or equity niche, is career wise advice.

Above all, fund managers should theoretically be able to extract more alpha from such markets. Of course, in the investment world, reality often deviates considerably from theory. So how have fund managers performed in a less efficient stock market?

Alpha Generation in the US Equity Market

To answer this, we first explored the power of fund managers to create alpha in the U.S. equity market. S & P’s SPIVA scorecards provide great insight into the performance of mutual fund managers.

They paint a rather bleak picture: 2% of U.S. large-cap mutual fund managers fail to beat their benchmark in 10 years between 2010 and 2020.

The S&P 500 components are the most traded and researched stock in the world, this should probably be expected. However, US small-cap fund managers have not done very well: despite all the hidden gems, 76% have lowered their benchmarks in the last 10 years.

Most capital allocators assume that expert knowledge has value. Real estate stocks (REITs) are somewhat unusual instruments, as they feature stocks, bonds and the real estate industry. Theoretically, such sectors should be given rich alpha opportunities for dedicated fund managers. Alas, even these markets are very efficient in the United States. More than three out of four REIT fund managers – 76% – failed to meet their criteria.

US Equity Mutual Funds: Poor Performance by Their Standards

Chart showing US Equity Mutual Funds: Percentage of their benchmark performance low
Source: S&P SPIVA Scorecard 2020, Factor Research

Less efficient market exploitation

Compared to their U.S. counterparts, emerging markets are less regulated and company information is not always disseminated equally. Data inequality is significantly higher and many markets, among them China, are affected by retail investors. Overall, it allows sophisticated fund managers to create substantial value for their investors.

But when we compare equity mutual fund managers from developed and emerging markets, they both had bad results. Among advanced market fund managers, 2020% lowered their benchmarks in the last three years of 2020, while for emerging market fund managers %%.

Equity funds have been working below their standards for the past three years

Equity funds have been low on their benchmarks for the past three years
Source: S&P SPIVA Scorecard 2020, Factor Research

Although investors tend to choose mutual funds based on three-year performance data, this is a relatively short period, and may not include a full boom-and-bust market cycle. Perhaps fund managers need more time to prove their skills and should evaluate them for a longer period of time.

Unfortunately, increased observation time does not improve vision. Mutual fund managers in emerging markets have performed slightly worse than their counterparts in developed markets. In the last five years, market% has performed below their benchmark, which is 0% for advanced market fund managers. And in the last 10 years, 85% of emerging markets have performed 82% less than their advanced market counterparts.

Equity funds fall short of their criteria: advanced vs. emerging markets

Equity funds chart below their criteria: Developed vs. Emerging Markets
Source: S&P SPIVA Scorecard 2020, Factor Research

Performance adjustment

To put it bluntly, the lack of alpha generation from mutual fund managers is nothing new. Academic research has identified this over the ages. Capital allocators insist that it is about identifying some funds that consistently generate additional income. This is an interesting topic to evaluate in emerging markets. Fund managers should have more opportunities to make competitive progress due to higher information inequality than in developed markets.

S&P also provides performance continuity data: it paints a really bleak picture for U.S. equity mutual funds. For example, only 3% of the top 25% of funds in 2016 were able to stay in the top quarter the following year. Over a four-year period, less than 1% did. In other words, there is no performance continuity.

In contrast, emerging markets show some performance adjustment over the next year. A random distribution would assume that 25% of the top quarter funds could maintain their position and achieve higher percentages of funding in Brazil, Chile and Mexico.

In its subsequent years, however, that percentage declined, indicating that almost no funds showed consistent performance. The best performing mutual funds lack a competitive edge across the stock market.

Performance Adjustment: Percentage of the remaining 2016 top quadrant funds remaining in the top quarter

Chart showing performance consistency: Remaining in the top quarter of the 2016 2016 top quartile fund
Source: S&P SPIVA Scorecard 2020, Factor Research

Emerging market hedge funds

Most emerging market mutual fund managers failed to perform, and the few that were there were lucky rather than efficient due to a lack of consistency. Perhaps limiting a set of stocks from a benchmark index is not just optimal for the alpha generation.

So what if we evaluate the effectiveness of emerging market hedge funds that are relatively unregulated? The overall market situation does not matter because these funds can go into long and short equities, bonds and currencies.

But even these highly sophisticated investors have struggled to meet their standards. The HFRX EM Composite Index shares the same trend of performance as the MSCI Emerging Markets Index, although volatility has declined. The return has been basically zero since 2012, excluding the increase in 2020 which reflects the Covid-1 stock stock rebound, which indicates beta instead of alpha.

Emerging market hedge funds vs. equities and bonds

Emerging market hedge fund vs. equity and bond showing chart
Source: HFRX, Factor Research

More thoughts

Emerging markets are less efficient capital markets with greater data inequality than developed markets. Microsoft is covered by more than 30 Wall Street research analysts and Amazon by more than 40. No EM stock is similarly verified, and most have a complete lack of institutional research coverage.

So why are emerging market mutual fund managers not taking advantage?

Tiles for the future of work in investment management: 2021 report

Management lowers the fee alpha, to be sure, but the primary reason is that stocks are difficult to pick, regardless of market. Emerging markets may have more alpha opportunities, but there are more risks. Argentina managed to escape by selling 100-year bonds in 2017, and Mozambique issued bonds in 2016 to finance its tuna fleet. No country can handle it today. Fortune changes rapidly in emerging markets where stability is less assured, which makes forecasts futile.

This means that focusing on the less efficient stock market is not a special career move, at least for those who are managing funds. Perhaps the smart advice is to follow the money, which is being poured into private markets such as private equity and venture capital. These are complex asset classes that are difficult to benchmark and calculate whether products are valued. Complexity can be the enemy of investors, but it is also the friend of asset management.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Mats Anda

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Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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