The 1974 Nobel Prize for economics was split between two economists with diametrically opposed views: Austrian free-market economist Friedrich Hayek, author of The Road to Serfdom; and Swedish socialist Gunnar Myrdal. In 2013, the Nobel committee was apparently divided again, this time over a more hotly contested question than capitalism vs. socialism: the efficient market hypothesis (EMH).
Eugene Fama first advanced the EMH in his PhD dissertation in 1995. Also known as the “random walk theory,” the EMH holds that all publicly available information is already discounted in asset prices, and therefore, no one can consistently “beat” the market. Dr. Fama was one of three 2013 Nobel laureates in economics.
But Yale’s Robert Shiller, also a 2013 Nobel Prize winner, doesn’t think much of the EMH. He is quoted in the New York Times saying the EMH “makes little sense, except for in fairly trivial ways,” and “I would not, however, recommend that monetary or fiscal authorities seek inspiration from his theories on how to stabilize the economy. He [Dr. Fama] doubts the existence of any bubble before this crisis, and his philosophy would have let banks fail at the beginning of it.”
In a recently published whitepaper, Detecting True Alpha in Highly Competitive Markets, Northern Trust weighs in on the debate, and the paper’s authors are firmly in the Fama camp. Authors Peter Mladina, David Moore, CFA, and Charles Grant, CFA, review the data and draw the conclusion that managerial skill is rare in public equities, and that returns that appear to reveal skill are typically derived from a mix of increased risk and dumb luck.
Detecting True Alpha in Highly Competitive Markets is built on the foundation of three previous studies:
- Eugene Fama and Ken French (2010)
- Cremes and Petajisto (2009)
- Amihud and Goyenko (2013)
In the first, Dr. Fama and Dr. French use four sources of returns to evaluate the performance of mutual funds:
- Market factor (exposure to broad stock market risk);
- Size factor (relative exposure to small cap stocks);
- Value factor (relative exposure to value stocks); and
- Momentum factor (exposure to stocks that previously experienced relative price appreciation).
These four factors are commonly known as Fama French Carhart (FFC). The first, “market risk,” is widely understood as beta, but the remaining three have often been misconstrued as alpha.
In the 2009 Cremes and Petajisto study, the authors advanced the concept of “active share.” This is the share of an investment portfolio that differs from its benchmark, and therefore provides the possibility of alpha. To the extent that a portfolio is identical to its benchmark, both in terms of investments and their relative sizes within the portfolio, then alpha is impossible.
The 2013 study by Amihud and Goyenko improves on the concept of active share by making their measure, selectivity, benchmark independent. Northern Trust’s Mladina, Moore, and Grant used the selectivity metric to conduct their own study of 959 mutual funds.
Northern Trust Study
According to Northern Trust and the whitepaper’s authors, 95% of the returns from the 959 mutual funds under review are attributable to the four FFC factors. After fees, the average mutual fund produced negative alpha of 0.82%, which is nearly identical to their 0.85% average expense ratio. “These results make clear that most of what is commonly expressed as alpha is either random luck or the result of imprecise adjustment for risk.”
Northern Trust concedes that the results suggest some true alpha among the top 2.5% of fund managers, but even more negative true alpha among the worst. Alpha is “mostly random,” the authors conclude, and “the advice to employ passive equity or engineered beta solutions is good advice.” For those who insist on seeking alpha, Northern Trust stresses due diligence, since the results of their study indicate that true alpha is truly hard to find.
For more information, download a pdf copy of the whitepaper.