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Less Than 1% of Managers Deliver Alpha: Here Are Details

Monday, September 17th, 2012

Seen correctly, active management may be the only service ever offered that costs more than the value delivered.”

That is a quote from Charles Ellis’ excellent paper on the “Mystery Of Underperformance” in the money management business. He looks at performance versus benchmarks, indices and versus the fees that are charged. His conclusions are supported by excellent empirical evidence.

“New research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, 75% of funds roughly match the market and have zero alpha, and well under 1% achieve superior results after costs—a number not statistically significantly different from zero.”

He addresses the growing disconnect between management fees and performance.

“For active management, true fees—incremental fees as a percentage of incremental added value—are more than 50% of the value delivered by the more successful active managers and are far higher, even infinitely higher, for the many less successful active managers.

Here’s why: The real marginal cost of active management is the incremental fee that active managers charge versus the incremental returns they deliver.”

And Mr. Ellis goes on to identify the culprits. He reviews the practices and habits of Investment Consultants, Investment Committees, Fund Executives as well as the managers. And he finds them all guilty.

“Evidence increasingly shows that a “crime” of extensive underperformance has been committed in mutual funds, pension funds, and endowments. … an investigation leads to a surprising, if inevitable, conclusion: The usual suspects—investment managers, fund executives, investment consultants, and investment committees—are all guilty.”

The one thing he does not do is explain how to help prevent investors from becoming victims.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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