Proper Benchmarking and Alpha
Sept 09, 2010 By: Mary Brunson
When you look at your own personal investments, or those of an foundation, 401(k) or defined benefit pension plan, proper benchmarking is the most critical factor in determining whether active managers possess the skill necessary to consistently deliver returns in excess of the risk-appropriate benchmarks.
A Little Background
In 1952, Nobel Prize winner and consultant to Index Funds Advisors, Harry Markowitz set forth his Nobel Prize winning notion that risk must be considered as well as return. Through his risk-reward scatter plot (LINK), you can estimate whether or not your investments have been optimized so that your expected returns are maximized for your current level of risk.
In 1964, Sharpe’s Capital Asset Pricing Model set forth the idea that the returns of investments are explained by how closely those investments have matched or correlated to the market portfolio. The market portfolio is considered a “beta” of one and investments with betas greater than one (more volatile) should have higher expected returns and visa versa. This single risk factor model is a common measure obtained from Morningstar or Lipper data, however, it only explains about 70% of the returns of diversified portfolios. This leaves room for benchmarking errors by active managers when they compare their returns to a single market portfolio and claim that they have beaten the market.
From Sharpe’s single risk factor model, assertions arose from active managers that the various active strategies, such as stock selection, manager selection, market timing, and sector rotation could produce returns in excess of the market, which is referred to as “alpha.”
This line of reasoning asserts there are mispriced securities and by avoiding the over-priced securities and acquiring the under-priced securities, active managers can beat the market. But passive investors have a very different perspective. They realize there are millions of willing buyers and sellers in the world, all of whom have easily obtainable and low cost access to publicly available information. In total, those market participants are trading about 10 billion shares per day based on this information. It is not plausible that the securities would be mispriced. To the contrary, publicly traded securities may be the most accurately and fairly priced item in the world. Stock and bond prices determined in a free market are instantly and continuously being updated based on new and randomly occurring information. The news describing the progress of global capitalism is on average positive. Therefore, the market increases in value over time as the result of the profits from capitalism.
The notion that active managers can skillfully and repeatedly beat markets is enticing, but academics have not been able to confirm “manager skill” in empirical research. Instead, they commonly label the very few managers who have beaten a multi-risk factor model as being just lucky. Unfortunately and by definition, luck does not persist.
Numerous studies have concluded that “alpha” is a myth and it essentially disappears when exposure to two other risk factors are properly measured. Therefore, the common assumption that the market portfolio, often measured by the S&P 500, is a sufficient benchmark for diversified portfolios has been shown to be incorrect.
In 2005, a study titled False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, by Laurent Barras, Olivier Scaillet, and Russ Wermers investigated the presence of true alpha in 2,072 domestic equity mutual funds for the 32 years from January 1975 to December 2006. It concluded that when properly benchmarked (through a multi-factor regression, as opposed to the single factor regression), 99.4% of active managers failed to demonstrate genuine stock picking skill.
The Real Test of Above-Market Returns
Eugene F. Fama of the University of Chicago and Kenneth R. French of Yale University examined each of the post-1927 returns of every stock in the domestic markets, as well as the volatility of those returns, in search of commonalities that might explain why certain stocks deliver higher returns than others. Their ground-breaking Multi-Factor Model showed that Sharpe’s CAPM, although quite elegant, is incomplete. In addition to a portfolio’s exposure to the market as a whole, two other factors explained stock market returns over time: These are the degree to which the market portfolio carries increased or decreased exposure to small company stocks and stocks with high book-to-market ratios, also known as value stocks.
Since 1927, the portfolio that carried higher exposures to these markets also carried higher returns. But through diversification, the volatility was dampened to about the same as the market portfolio. This is why the Index Funds Advisors’ full equity Index Portfolio 90 is tilted toward small and value companies and invests in 12,000 companies, as opposed to 500.
The findings of Fama and French show that their three factors (market, size and value) explain more than 96% of stock market returns.
Over the last 82 years, the size premium (for greater exposure to small companies) has been 3.17%, and the value premium (for greater exposure to high book-to-market companies) has been an additional 5.04%. The market premium for broad market exposure above the return of 30 day T-bills has been 7.50%. Fama and French’s subsequent 5-Factor Model shows the risk premiums for fixed income, as well. These are term risk and default risk, where the premiums are 2.03% and 0.31%, respectively.
Fama and French further concluded that not all risk factors are worth taking. For stocks, 82 years of data have shown that growth stocks are not efficient uses of risk, with relatively high risk and low returns. For fixed income, long-term instruments carry higher term risk, but have not provided higher returns to adequately compensate for these risks. For investment committees who select active fund managers, these findings are critical, summarizing that true alpha can only be identified once investors have properly benchmarked against indexes that incorporate the multiple factors identified by Fama and French. And when this occurs, alpha becomes just a matter of luck. This leads investors to the unavoidable conclusion that they should cut their costs in half and simply buy a portfolio of indexes in the form of a small value tilted, globally diversified portfolio of index funds. The key issue remaining is what risk level is appropriate for each investor or group of investors and which blend of indexes is most likely to maximize returns at that level of risk. Then hold on, rebalance and let the earnings of capitalism justify the increased values over time.
These concepts are substantive and have endured much scrutiny under the watchful eye of peer reviews, Nobel Prize committees, and the institutional investing world largely governed by the Prudent Investor Rule and its five principles of prudence. They are also the guiding principles for the Index Funds Advisors approach.