The debate between active and passive investments has become more heated in the past decade, with the number of academic studies nearly outnumbering the number of active managers themselves. Indeed, the traditional capital asset pricing model, or single-factor model as it is now commonly known, attempted to identify the alpha empirically as a value that does not change over time while more recent multi-factor models attempt to add additional factors such as value and market momentum factors.
Fundamentally, however, the ability of any manager to add alpha has to be considered over the context of a full market cycle and furthermore in bull markets and in bear markets. Only then can the appropriate insight be gained on the precise market environment in which active management added or detracted value.
The picture is further complicated when you take into account the market timing abilities of managers, which many argue is a necessity in sustainable alpha generation. In this instance, we are attempting to understand whether managers can raise beta in a rising market or reduce it in a falling market. Additionally, manager tenure, net expense ratio and volatility (defined as standard deviation) tend to have meaningful impacts on Alpha generation while turnover ratio, concentration level and asset size surprisingly do not appear to have any statistically significant impacts.
Detailed studies carried out in the US conclude that active managers are generally more conservative and exposed to less market risks than their passive benchmark indices regardless of bull or bear markets. In the case of the FundQuest study, the average beta for all asset classes in the 73 investment categories analysed was found to be 0.80 in bull markets and 0.81 in bear markets. One of the most significant findings was that managers who provided better downside protection or guaranteed alpha in one full market cycle generally performed well in the following full market cycle, adding even higher alpha.
Before adjusting for beta risk, active managers had on average generated positive excess returns in bear markets and negative excess returns in bull markets. However, the situation reverses after adjusting for beta risk, where active managers generally generated higher real alpha (risk-adjusted returns) than their passive benchmarks in bull markets and lower alpha than their benchmarks in bear markets.
In conclusion, there are managers generating positive real alpha, even in categories where active managers have historically underperformed their benchmarks. However, the percentage of managers in each investment category that outperform their respective category benchmarks does vary significantly from category to category but is estimated at around an average of 18 per cent across all sectors on a rolling three-year basis.
Therefore, opportunities exist in every space but due diligence is required in the fund selection process to identify mana-gers with the potential to generate real alpha. Or to put it another way, there is no substitute for kicking the tyres.
<B>Tim Clift is chief investment officer at FundQuest in Boston</B>