It’s increasingly difficult for active managers to generate alpha, argues Craig Lazzara, senior director, Index Investment Strategy at S&P Dow Jones Indices. He spoke on a panel at a CFA Society Toronto event last week.
Alpha generation is a zero-sum game, he says. Alpha won by one market player is underperformance suffered by another; so, as passive investing becomes more common, there will be fewer losers. That means fewer losses and less alpha to go around.
He illustrates with two hypothetical scenarios.
Scenario A: Total market capitalization is $20 trillion, all actively managed. That means $10 trillion will outperform and $10 trillion will underperform. Now assume the average underperformance is 5%. That works out to $500 billion (5% × $10 trillion), which is “the total pre-cost outperformance available to the winners,” explains Lazzara.
Scenario B: Same market capitalization as Scenario A, but in this case 90% is actively managed ($18 trillion) and 10% is in index funds ($2 trillion). That means $9 trillion on the active side outperforms, and the other $9 trillion underperforms.
“The average underperformance, given that a passive alternative exists, will be less than it was when there was no passive alternative,” argues Lazzara. On that basis he suggests using 4% rather than 5%.
That works out to $360 billion (4% × $9 trillion) in underperformance, “which means there’s $360 billion in potential alpha to be divided by the winners.”
Bottom line, the 10% reduction in active AUM led to a 28% reduction in outperformance.
Another reason active management’s harder than it used to be has to do with dispersion.
“Dispersion measures the average difference between the return of an index and the return of each of the index’s components. In times of high dispersion, the gap between the best performers and the worst performers is relatively wide; when dispersion is low, the performance gap narrows,” Lazzara explains in a recent blog post.
Dispersion provides a measure of the potential outperformance of active management and factor indices—any non-cap-weighted strategy. High dispersion’s ideal for active managers; narrow dispersion reduces opportunities.
Lazzara notes a pattern: 55% of the months when the market’s down the most are high dispersion months. So, “there’s a clear interaction of market return and dispersion [….] Dispersion is at its highest level in the biggest negative months.”
Stock pickers should devote most attention to sectors exhibiting a combination of high dispersion and low correlation, says Lazzara. For instance, on the S&P 500 energy is a low-dispersion sector; but its constituent stocks are highly correlated, so they tend to move in tandem. It’s more important, therefore, to know the direction of the sector as a whole, rather than trying to pick one name over another.
By contrast, technology has high dispersion with low correlation among names within the sector. So, “a stock selector trying to figure out where to focus his energies” would be better off with tech than energy, argues Lazzara.
He adds: “If you think about dispersion as a measure of opportunity, in the last several years there has been, for stock selectors, a relatively small amount of opportunity” in the U.S. compared to five years ago.
Europe also has very low dispersion relative to historical trends. Canada’s a bit above average as of the end of last year, “but not extraordinarily high,” says Lazzara. Emerging markets are in a high-dispersion environment, so they’re ripe for active managers.
Still, Lazzara says his firm’s SPIVA reports paint a bleak picture for stock pickers: most active managers don’t beat their benchmarks, and those who do don’t do so consistently.
Defending active management
Noah Blackstein, portfolio manager at 1832 Asset Management, says the market would suffer without stock pickers. “If there are no active managers, who’s going to change the weights of the index? If all money is passively managed, who determines the stocks that get a higher or lower weight?
“If all money was passively managed in the year 2000, Nortel would still be 60% of the Canadian index. You need active managers for indices to be efficient. The more money that’s passively managed, the less efficient the indices are.”
He also takes issue with the zero-sum view of active management. “The concept that for every active manager who wins there’s one who loses is ridiculous.”
Blackstein suggests SPIVA reports show such dismal results largely because so many managers who claim to be active are actually closet indexers, skewing the data. “If you have a closet index fund with a 2% management fee, get rid of it,” he says.
But truly active managers—those with high active share scores—have been proven to outperform the index over time, says Blackstein, citing Martijn Cremers and Antti Petajisto, the researchers who devised the active share metric.
To make a fairer comparison between active and passive, he concludes, you need to compare index strategies against managers with high active share scores.