Picking the winner
25 November 2016 | Portfolio construction
Many investors are searching for alpha – a portfolio that will outperform a benchmark. Actively managed funds are the obvious choice for reaching this goal. But more often than not, investors with active funds are left disappointed, having been unable to pick the winning active funds.
So what do investors need to know and what should they look for? First, investors need to be comfortable taking on active risk when using active funds. Recent research from Vanguard* showed that, although there are some actively managed balanced funds that significantly outperformed their benchmarks over time, the average of these funds reduced returns and increased return variability compared with funds that passively tracked their benchmark.
We know that active management leads to increased uncertainty and potentially more risk, and only a minority of active managers outperform. But for those seeking outperformance, it can be helpful to know how many funds not only outperformed, but also produced statistically significant alpha.
Figure 1 shows the results for our study of balanced funds in the United Kingdom. Of the 743 funds studied, the overwhelming majority (628) had alpha that was statistically indistinguishable from zero. Twelve percent (92) delivered a statistically significant negative excess return, while only three percent (23) delivered a statistically significant positive excess return.
If you look at the figures on an asset-weighted basis, which considers the amount of money invested rather than the number of funds, the probability of outperformance changes. The percentage of assets outperforming their benchmark increases to 6%, but so does the amount of assets producing zero alpha, admittedly only slightly from 85% to 86%.
Clearly, statistically significant positive alpha is difficult to achieve. No doubt manager skill plays a role, but if we take a closer look at these 6% of funds, we can see there may be another important – and readily identifiable – difference that could distinguish this particularly successful group. On average, they had lower expenses than the consistently underperforming funds.
This generally held true in the other markets we analysed – the United States, Canada, Australia and Japan.
So does this mean that when searching for alpha, funds with lower costs can help investors achieve that goal? Lowering the costs paid for active management certainly doesn’t guarantee outperformance, but it’s a great place to start.
Fund characteristics for UK funds
January 1990 – September 2015
*The global case for strategic asset allocation and an examination of home bias. Brian Scott, James Balsamo, Kelly McShane and Christos Tasopoulos, Vanguard, August 2016.
This article is designed for use by, and is directed only at, persons resident in the UK. This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors.
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Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority.