Practical analysis for investment professionals
11 October 2021

Less Efficient Markets = Higher Alpha?

Introduction

Students often ask me for career advice. It is not a particularly satisfying experience. On the one hand, these are often exceptionally bright and hard-working people, with Oxford or Cambridge PhDs in chemical engineering, astrophysics, or some other challenging discipline. I wish they would stick to science and create something meaningful for our civilization rather than try to generate a few excess basis points per annum.

On the other hand, some students decided early on to pursue careers in finance and studied accordingly. Telling them to build better fertilizers or rocket ships makes little sense. But finance career advice is getting harder and harder to provide. Why? Because global capital markets are already highly efficient and each day machines are grabbing more and more market share from humans. The career prospects for someone with a master’s degree in finance and some basic Excel skills are steadily diminishing.

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Naturally, it depends on the role. Most students dream of becoming fund managers and managing money. Exchange-traded funds (ETFs) have become their key competitors. So if fund manager is the career aspiration, then maybe focusing on less efficient markets, either private or equity niches, is the savvy career advice.

After all, fund managers should theoretically be able to extract more alpha from such markets. Of course, in the investment world, reality often deviates substantially from theory. So how have fund managers performed in less efficient stock markets?

Alpha Generation in US Equity Markets

To answer that, we first investigated fund managers’ ability to create alpha in the US equity markets. S&P’s SPIVA Scorecards offer great insight into the performance of mutual fund managers.

They paint a rather depressing picture: 82% of US large-cap mutual fund managers failed to beat their benchmark over the 10 years between 2010 and 2020. From 2000 to 2020, an astonishing 94% failed to do so.

Given that S&P 500 constituents are the most traded and researched stocks on earth, this perhaps should be expected. However, US small-cap fund managers did not fare much better: 76% underperformed their benchmark over the last 10 years, despite all the hidden gems.

Most capital allocators assume that specialist knowledge has value. Real estate stocks (REITs) are somewhat unusual instruments as they feature stock, bond, and real estate industry characteristics. Theoretically, such sectors should offer rich alpha opportunities for dedicated fund managers. Alas, even these markets are too efficient in the United States. More than three out of four REIT fund managers — 76% — couldn’t beat their benchmarks.


US Equity Mutual Funds: Percent Underperforming Their Benchmarks

Chart showing US Equity Mutual Funds: Percent Underperforming Their Benchmarks
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Exploiting Less Efficient Markets

Compared to their US counterparts, emerging markets are less regulated and company data is not always disseminated equally. Information asymmetries are significantly higher and many markets, China among them, are dominated by retail investors. Overall, this should allow sophisticated fund managers to create substantial value for their investors.

But when we compare equity mutual fund managers from developed and emerging markets, they both fared poorly. Of developed market fund managers, 74% underperformed their benchmarks in the three years ending 2020, compared to 73% for emerging market fund managers.


Equity Funds Underperforming Their Benchmarks over the Last Three Years

Chart showing Equity Funds Underperforming Their Benchmarks over the Last Three Years
Source: S&P SPIVA Scorecards 2020, FactorResearch

Although investors tend to select mutual funds based on three years of performance data, it is a relatively short period, and may not include a complete boom-and-bust market cycle. Perhaps fund managers need more time to prove their acumen and should be evaluated over longer time horizons.

Unfortunately, extending the observation period does not improve the perspective. Mutual fund managers in emerging markets performed slightly worse than their counterparts in developed markets. Over the last five years, 84% underperformed their benchmarks, compared to 80% for developed market fund managers. And over the last 10 years, 85% underperformed in emerging markets vs. 82% of their developed market peers.


Equity Funds Underperforming Their Benchmarks: Developed vs. Emerging Markets

Chart showing Equity Funds Underperforming Their Benchmarks: Developed vs. Emerging Markets
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Performance Consistency

To be fair, the lack of alpha generation from mutual fund managers is nothing new. Academic research has flagged it for decades. Capital allocators emphasize that it is all about identifying the few funds that generate consistent excess returns. This is an interesting point to evaluate in emerging markets. Fund managers should have more opportunities to gain a competitive edge given higher information asymmetries compared to developed markets.

S&P also provides data on performance consistency: It paints a truly dismal picture for US equity mutual funds. For example, only 3% of the top 25% of funds in 2016 managed to stay in the top quartile the following year. Over a four-year period, less than 1% did. Stated differently, there is no performance consistency. 

In contrast, emerging markets show some performance consistency in the following year. A random distribution would assume that 25% of the top quartile funds can maintain their position, and a higher percentage of funds achieved that in Brazil, Chile, and Mexico.

In the years thereafter, however, that percentage plunges, demonstrating that almost no fund exhibits performance consistency. The best-performing mutual funds seem to lack a competitive edge across stock markets.


Performance Consistency: Percent of 2016 Top Quartile Funds Remaining in Top Quartile

Chart showing Performance Consistency: Percent of 2016 Top Quartile Funds Remaining in Top Quartile
Sources: S&P SPIVA Scorecards 2020, FactorResearch

Emerging Market Hedge Funds

Most emerging market mutual fund managers failed to outperform, and the few that did were lucky rather than skilled given the lack of consistency. Perhaps being constrained to a set of stocks from a benchmark index just isn’t conducive to alpha generation.

So what if we evaluate the performance of emerging market hedge funds that are relatively unconstrained? The overall market conditions should not matter since these funds can go long and short equities, bonds, and currencies.

But even these highly sophisticated investors have struggled to beat their benchmarks. The HFRX EM Composite Index shared the same trends in performance as the MSCI Emerging Market Index, albeit with reduced volatility. The return was essentially zero since 2012, except for an increase in 2020 that mirrors the COVID-19 stock rebound, which indicates beta rather than alpha.


Emerging Market Hedge Funds vs. Equities and Bonds

Chart showing Emerging Market Hedge Funds vs. Equities and Bonds
Sources: HFRX, FactorResearch

Further Thoughts

Emerging markets are less efficient capital markets with larger information asymmetries than developed markets. Microsoft is covered by more than 30 Wall Street research analysts and Amazon by more than 40. No EM stock is similarly scrutinized, and most lack institutional research coverage altogether.

So why are emerging markets mutual fund managers unable to take advantage? 

Tile for Future of Work in Investment Management: 2021 Report

Management fees reduce alpha, to be sure, but the primary reason is that stock picking is simply difficult, regardless of the market. There might be more alpha opportunities in emerging markets, but there is also more risk. Argentina managed to get away with selling a 100-year bond in 2017, and Mozambique issued bonds to finance its tuna fleet in 2016. Neither country could likely manage this today. Fortunes change quickly in emerging markets where stability is less assured, which makes forecasting futile.

What this means is that focusing on less efficient stock markets is not a particularly sound career move, at least for those pursuing fund management. Perhaps the smarter advice is simply to follow the money, which is pouring into private markets like private equity and venture capital. These are complicated asset classes that are difficult to benchmark and to calculate whether products offer value. Complexity may be a foe of investors, but it is a friend of asset management.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Mats Anda


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About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

1 thought on “Less Efficient Markets = Higher Alpha?”

  1. Peter says:

    “Management fees reduce alpha, to be sure, but the primary reason is that stock picking is simply difficult, regardless of the market.”

    Let’s critically consider this statement.

    If the main reason for the majority of active fund managers underperforming the index were indeed the “difficulty” in analyzing stocks, then why would a static, broad collection of arbitrarily chosen stocks (aka the benchmark or index) consistently outperform the curated lists selected by investment management professionals?

    Under the author’s logic, this phenomenon would require an extraordinary explanation!

    Nay, the real reason for underperformance is much simpler:

    Real portfolios have friction costs (management fees, trading commissions, withholding taxes, market impact costs, implementation delays) that imaginary portfolios do not.

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