Don’t Fear the (Alpha) Reaper

In Industry Illusions, Retail on

“[People] occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing ever happened.” – Winston Churchill

Non Timetis Messor (Latin – Don’t Fear the Reaper)


Let us preface this article by saying that we can’t for the life of us figure out why any investor cares about beating the market in the first place. To us, the whole concept of beating the market is a red herring. The only people who should be concerned with beating the market are investment managers themselves, because their compensation is directly tied to this specific objective. For the rest of us, our financial goals have almost nothing to do with beating the market. We care about consistent results with few major twists and turns that allow us to grow our savings at or above the rate of inflation.

Secondly, we have nothing against active management. From an economic perspective, active management is critical to the establishment of equilibrium price signals for a wide variety of transactions. From an investment standpoint, a select few areas of active management offer substantial opportunities for sustainable strong returns with manageable risk. For example, we are big believers in trend following and global macro strategies. Further, we acknowledge that structural market dislocations present infrequent, fleeting, but highly lucrative opportunities in many markets from time to time. The dislocation in the Canadian asset backed commercial paper space, or the U.S. leveraged loan space after the credit crisis, are easy to recall examples.

Rather, our beef is specifically with traditional, fundamentally based stock-picking investment mandates, of which traditional mutual funds are a very representative sample. As such, the following analysis, which focuses on these stock-picking mutual fund managers’ inability to beat their respective equity indices, draws no conclusions about active management in general. I hope we’re clear on this point.

Broken Record Alert

We’re going to say it again: beating ‘the market’ is a mug’s game. We’ve repeated this ad nauseum on this blog, but the evidence keeps pouring in. Look no further than the latest SPIVA®  (S&P DOW JONES INDICES VERSUS ACTIVE FUNDS) report, which by the way echoes the exact same themes as all previous SPIVA® reports. The SPIVA® authors summarize thusly: “The only consistent data point we have observed over a five- year horizon is that a majority of active equity managers in most categories lag comparable benchmark indices.”

The SPIVA® reports are worth paying attention to because they cover all mutual funds – in market cap weight and equal weight – in every major category. Further, the authors assiduously adjust for the many biases that infect many analyses of mutual fund performance. For example, the SPIVA® report accounts for the fact that 30%-40% (depending on category) of all mutual funds were delisted over the past 5 years. Fund companies don’t delist top funds, so an analysis conducted only on those funds that survived would naturally only cover the best performing funds. SPIVA® counts delisted funds in their analysis to offer an unbiased comparison.

We should note before we present the grisly details that this article is NOT a condemnation of mutual fund managers. Most managers are exceptionally well qualified with MBAs, CAs and CFAs. Further, they are passionate about investing, have an informational edge, and are possessed of very high levels of integrity. Also, the mutual fund structure tends to have some advantages over other investment vehicles like the now ubiquitous “Separately Managed Accounts” structure, such as economies of scale and low trading costs.

But perhaps most importantly, these managers spend all their time thinking about the investment process, while many other investment professionals are distracted by sales, marketing and customer service efforts. If anyone should be able to ‘beat the index’ it’s these guys and gals.Unfortunately, very few succeed, as the table below illustrates with painful clarity.

What gives? If these guys and gals are so smart, qualified, and passionate, why do so few beat the market? The answer is simple and twofold. First, the index that they are measured against has no costs and no fees. That one’s easy. The other reason is a little more esoteric: these guys are all competing against each other because excess returns over the benchmark are a zero sum game. And by virtue of the fact that there are so many smart, passionate, qualified guys competing for the same golden egg, they’ve effectively killed the golden goose.


Source: SPIVA® 2012

What exactly is the takeaway for YOU? First of all, the likelihood that your Advisor is going to ‘beat the market’ with his stock picks – or by choosing mutual fund or SMA managers to pick stocks – is extremely small. Over any given year, if you were to pick randomly, your chances range between 1 in 40 (for U.S. equity mandates) and 1 in 8 for Canadian Focused Equity mandates. [Canadian Focused Equity allows a manager latitude to range allocations between Canadian, U.S. and global stocks, but with a bias toward Canadian securities].

Another interesting observation is that dividend fund managers were about 50% less competitive than traditional Canadian Equity fund managers, in that only 5.6% of dividend focused managers beat the passive dividend benchmark. Translation: if you want exposure to dividend stocks (and by the way we think this is a bad bet with every Tom, Dick and Harry chasing dividend stocks into stratospheric valuations), fire your active dividend manager and buy a dividend ETF for less than 0.5% per year in management fees. No brainer.

Non Timetis Messor [Don’t fear the reaper]

But again, the broader – and we feel much more important – point is that the whole concept of ‘beating the market’ is insanely misguided. ‘Beating the market’ won’t get anyone to retirement, or improve anyone’s standard of living in retirement, and ‘beating the market’ won’t help any institution sustainably fund its long-term obligations. These objectives rely on strong, consistent returns with no major ‘whammies’ along the way.

In our experience, most investors would be much better served by pursuing structurally diversified strategies of passive ETFs which are constructed to track the major global asset classes with the lowest possible fees. Remember, achieving index returns puts you ahead of 84% – 97% of stock pickers!

We mentioned above that smart, qualified stockpickers can’t succeed because their intense competition has killed their golden goose. Consider this: would you rather compete in an arena where many skilled players are competing for a small pie, or would it be better to compete in a space where there are few competitors competing for a really large pie? If you’d prefer the latter, you might wish to consider strategies that seek extra returns and lower risk by moving capital among a variety of liquid, low cost ETFs. This space has very few competitors, and many structural impediments to arbitrage, which presents substantial opportunities. For more information on what’s possible in the space please see our article or longer whitepaper on Adaptive Asset Allocation.