With active managers, is alpha really just beta?

(MoneyWatch) The research on the ability of active managers to deliver alpha -- performance above the appropriate risk-adjusted benchmark -- makes very clear that:

• A minority of active managers outperform appropriate benchmarks
• The longer the time horizon, the smaller the percentage
• There is no persistence of outperformance beyond the randomly expected, which is why the SEC requires the standard disclaimer about past performance not being a prologue.

Given the above, why is it that we occasionally see reports showing that a majority of active managers have outperformed? For example, a recent Morningstar report found that 86 percent of actively managed taxable bond funds outperformed their benchmark over the four-year period ending Dec. 31, 2012, as measured by the Barclays U.S. Aggregate Bond Index. The answer lies in Nobel Laureate economist William Sharpe's observation that "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

Sharpe's insight was that Morningstar's results were likely to be explained by the actively managed funds taking more risk -- either term (buying longer maturities) or credit (buying lower rated credits) - -than is contained in the benchmark. 

In other words, it would be like a large-cap growth fund buying small value stocks and claiming alpha. Really, that's beta, more exposure to the risk factors of size and value, not alpha. To see if the outperformance of actively managed bonds relative to the Barclay's Aggregate benchmark was fueled by alpha or beta, Vanguard's research team studied the performance of actively managed bond funds for the period 1998-2012. The following is a summary of their conclusions.

• The performance of actively managed funds was strongly influenced by the results of the corporate bond sector.
• The universe of actively managed funds has employed a significant and persistent overweighting to corporate bonds (underweighting safer government bonds).
• The persistent overweighting to corporate credit risk, and not dynamic or tactical portfolio management, was the primary driver of performance for funds benchmarked to the Barclays U.S. Aggregate Bond Index -- the outperformance was beta (in the form of credit risk), not alpha. The difference in returns between corporate bonds and government bonds explained 89 percent of the pattern of excess returns.
• The greater exposure to credit risk showed up in volatility, with 79 percent of actively managed funds having greater volatility than the benchmark.

Vanguard found that the returns of the actively managed funds could be effectively replicated by using a blend of 80 percent low-cost total bond market fund and 20 percent low-cost corporate bond fund (matching the overweighting to corporate bonds of the actively-managed funds. For the 15-year period, the low-cost total bond fund returned 5.8 percent, the actively managed bond funds returned 5.6 percent and the 80/20 allocation returned 5.9 percent. And the r-squared of the blended 80/20 portfolio with the actively-managed funds was 92 percent.

In other words, investors in higher-cost, actively managed funds were paying for alpha, but receiving beta -- which could be obtained more cheaply by investing in low-cost, passively-managed corporate bond funds (such as index funds and ETFs). That means Sharpe was right. The benchmark used was incorrect, and the performance should have been adjusted to take that into account. In addition to the superior performance of the low-cost, passively-managed funds, investors in them had more control over the risks of their portfolios. They also had the benefit of total transparency. And they were paying lower fees.

There is one more important point we need to cover. Remember that for active managers to outperform there must be another group of investors who "lost" to the market. Today's bond market is even more dominated by institutional investors than is the stock markets. Thus, it's extremely difficult to think of a likely group of victims who the actively-managed funds are going to exploit sufficiently to generate enough alpha to cover their greater expenses. 

That's why active investing with bond funds is just as much of a loser's game as it is with stock funds.