Live

Watch CBSN Live

The Bigger Active Funds Get, the Worse Their Alpha

As strategies get overcrowded, the alphas of active funds tends to shrink.Active management attempts to generate alpha by exploiting perceived mispricings. However, there are capacity constraints to any successful active strategy. Successful strategies tend to rapidly become more crowded -- either through more dollars flowing to the alpha generators (causing trading costs to increase) and/or "copy cats" entering -- and the ability to generate alpha deteriorates.

The authors of the 2010 paper "Capacity and Factor Timing Effects in Active Portfolio Management" studied the existence and nature of capacity constraints in active portfolio management. They found that the reported returns of open-end mutual funds generally differ from the realized returns of shareholders -- the time-weighted returns reported by funds are about 1.2 percent greater than the dollar-weighted returns earned by investors.

The difference arises from two sources:

  • A "timing effect" resulting from individual shareholders timing their investments (or disinvestments)
  • A "capacity effect" resulting from alphas deteriorating when exposed to cash inflows
In addition, fund flows can cause managers to engage in costly transactions, especially if the flows are poorly timed (such as redemptions in bear markets when liquidity is at an additional premium). The following is a summary of the author's findings:
  • The capacity and timing effects of actively managed funds were 50 and 70 basis points, respectively.
  • The negative timing effects were present in all nine of Morningstar's investment styles, though they were much greater in growth funds.
  • Index funds displayed no capacity effects, and timing effects weren't significantly different from zero. (Index fund investors appear smarter, or at least more disciplined.)
  • The capacity effect was greater for small-cap and growth funds -- small-cap growth funds faced the greatest capacity constraints.
  • The timing effect was greater for large-cap and growth funds.
  • Retail share classes suffered timing effects several times the magnitude of institutional share classes -- institutions suffer less from the timing of their capital flows than retail investors.
  • Fund managers can reduce exposure to the timing effect by holding larger cash balances. However, this negatively impacts fund returns.
  • Front-end loads suppress both timing and capacity effects.
  • Marketing fees explained timing. Higher 12b-1 fees were linked to the poor timing of flows and were consistent with marketing encouraging investors to chase hot funds/sectors.
  • Funds that were members of large fund families have larger negative timing effects -- the ease of switching contributes to bad investor behavior.
The above findings add to the body of evidence finding that successful active management contains the seeds of its own destruction, which helps explain why there is an overwhelming body of evidence against the persistence of outperformance beyond the randomly expected.

More on MoneyWatch:
If Muni Bond Defaults Spike, It Won't Be for Lack of Trying to Fix Problems 3 Reasons to Avoid Corporate Bonds How Surprises Play a Role in Economic Conditions What the Greek Crisis Means for Your Portfolio Investment Quiz: Who Said It?
Three ways I can help you become a wiser investor: