Participants in financial markets are engaging in a zero-sum game amongst themselves. For any investor to generated excess returns over the market there must be someone that underperformed the market. Alpha works the same way, for every manager that has produced positive alpha, there must be someone that produced negative alpha. Yet, we are all aware of superstar managers that have made their clients rich. So, how were they able to do that, why is the average investment manager struggling, and will they likely continue to struggle?
For an investment manager to outperform, he must have an advantage. That advantage could be educational, cognitive, or informational among others. For example, insiders have always had an advantage, they have non-public information that can assist them in timing their purchases and sales of the company’s stock. This advantage is asymmetrical and unfair, so the Securities Exchange Act of 1934 outlawed it. Another set of people that had an advantage in the early 20th century were those who knew how to read financial statements. Imagine a well-versed financial statements expert buying and selling securities with people that have a poor understanding of how to measure the profitability of a company or the value of its assets (for example, Benjamin Graham versus your average 1930s market participants). Next, imagine someone who not only knows how to get around financials, but he is also able to evaluate management’s character, skills, and his own cognitive biases (Warren Buffet and Charlie Munger versus your financially literate accountant). Looking at the institutional ownership chart below, we can see that until the 1990s, the majority of market participants were retail investors, meaning average joes owned and traded stocks. Most of those individuals were neither full time investors or good financial evaluators, nor great managerial judges. Because of their lack of expertise, individual investors were easy pray for skilled investors. With the rise of the mutual fund, the percentage of direct stock ownership began to slowly decline, as more and more money began being managed professionally. A climax was reached in the 90s, as professional investors surpassed individual investors.
The rise of professional money management had some major market implications:
- Ever increasing competition. Professional managers are full time investors and more skilled compared to your average retail investor. As we know, in a market for every buyer there must be a seller. The increasing talent level meant that it will be harder and harder to find trades with “clueless” investors. Which leads us to the second point.
- Securities started trading closer to “intrinsic value”. Most of these managers attended the same ivy schools, learned from the same professors or investors (Benjamin Graham, Fisher, Buffet, etc.), used similar models, and arrived with similar ‘intrinsic values”. This led to a decline in standard deviation of excess returns over (see chart above).
Warren Buffett warned Berkshire investors not to expect outperformance like the 50s, 60s, and 70s. Thanks to his and other top investors generosity of sharing their knowledge and skill, many current professional managers use similar techniques to select stocks.
In addition, the growing allocation of assets to index investing puts rising pressures on professional money management. Active market participants (professional managers and retail investors), help establish market prices by trading amongst one another based on their respective valuations of securities. Index investing focuses on matching market-cap weightings of securities, which in turn is the price established by those same active participants. Basically, index investors are free riders, as they do not generate any additional information for the markets and do not provide liquidity. Index investing further heats up the competition. The active participants most likely to lose their assets to indexing are the poor performing or unlucky active portfolio managers. This leaves less opportunities for the most skilled active investors.
In summary, do not expect active investing as an aggregate to outperform or generate excess alpha. It is not possible, as active investors charge higher fees, and as an aggregate, they can only match gross market returns. Many smart investors have simply transition to venture capital and private equity, as those markets have informational and structural asymmetries.