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End to ‘Alpha’ a Stress for Fund Managers

It is no secret that investors of all stripes have struggled to beat the market since the financial crisis. The majority of hedge funds, for instance, have trailed both global stocks and bonds since the start of 2010, meaning that they have not added value to the simplest of portfolios.

NYSE trader
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NYSE trader

Mutual funds are not performing as badly as last year, when just 27 percent offered better returns than the benchmark they choose to track, according to research group Lipper. But, again, the majority still trail in 2012.

Much of the blame for this tends to be attributed to the fact that markets now move to a drumbeat of statements from politicians and central bankers, such as the head of the US Federal Reserve. “All 500 S&P companies have the same chairman and his name is Ben Bernanke,” says Jurrien Timmer of the Fidelity Global Strategies Fund.

It is also true that securities within markets, as well as far-flung debt and equity markets have been trading more “in sync” with each other: the willingness of investors to take on risk being a common factor behind price moves.

But something more fundamental may be happening. Changes to the availability of information and in the capital to act on it mean it has become harder, perhaps impossible, to beat the market consistently through active management. There may be no more “alpha”.

Consider that any young business school graduate with the money to pay for the data feed can sit in front of a Bloomberg terminal and, with a few keystrokes, bring up years of financial statements for businesses across the globe. Tap again and an investor can ponder charts showing the predictions of professional analysts, details of the company’s debt, as well as the identities of shareholders, competitors and peers.

The service, and others like it that sit user friendly screens atop vast databases of information, have made it far easier to analyze asset prices, but harder to gain an edge over peers by acting faster, or more smartly.

John Longhurst, head of emerging market equity research for Pimco, says that when he became a stock analyst in the mid-1980s, “information advantage covering continental European companies was often little more than being able to get an annual report in English”.

Mr. Longhurst, who previously worked for Capital Research, says that “10 to 15 years ago I could sit with clients and talk about how being globally connected through multiple offices and working in a well-resourced entity were competitive advantages. No more.”

Pimco is organizing its research teams around global value chains rather than by simple sector or country to spot attractive investments. But the move by the world’s largest corporate bond manager as it tries to build a new equity business highlights how much capital, both financial and intellectual, is chasing fleeting opportunities.

“When hedge funds were at $200 billion, there were probably a lot of inefficiencies in the markets that the smart guys could identify,” says Denis Bastin, a consultant to asset managers. Now that the industry is more than 10 times that size, however, before using leverage, the market inefficiencies must be far larger for it to generate alpha, even as the number of smart investors hunting them has mushroomed.

The effect can be seen in the narrowing dispersion of hedge fund returns – the difference between the best and worst performers. In 2011, while the average hedge fund lost money, according to HFR, a data provider, the top 10 percent of funds made a respectable 19.5 percent on average.

Yet that respectable return was the worst performance by the hedge fund elite since 2000. The top 10th of the industry had made at least twice as much in each year of the previous decade. These relatively muted returns continued into 2012.

Of course, a world of very low interest rates may simply have shone more light on returns for active management that have always been below par. Past studies have found that mutual funds, in aggregate, fare worse than passive index following.

Russel Kinnel, head of Mutual Fund research for Morningstar, says “relative to say indexes, or other benchmarks, fund performance does not change that much”. He finds that in any given year about a third of active funds perform well.

Even among bond funds, which have taken the lion’s share of US investor inflows since the 2008-09 financial crisis, less than a third have beaten their benchmark on average each year since 2000, according to Lipper.

Experienced investors, then, struggling to match past performance may just be baseball players in world suddenly playing cricket. The skills needed to select securities that worked as stocks and bonds rose in value for much of the preceding three decades have simply become out-of-date.

“Every time we go through a new market cycle a few of the heroes get shed,” says Mr. Kinnel. This market favors the few able to distil the intricacies of Beijing politics into investment themes, or to spot where the next Samsung or Apple will rise.

Mr. Bastin says: “Yes, we have a lot of information that is readily available, but you still have to interpret it. What really counts is the skill set and the ability to interpret those numbers.” Such skills, though, are held by perhaps 5 to 10 per cent of the current investor universe. “Most of the others have no business being in the space.”