Outperformance Ain’t Alpha

If you can explain it, you can replicate it more cheaply

August 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Outperformance and alpha are not the same
  • One is the difference from a benchmark, the other is the unexplained return
  • A contribution analysis helps understanding the return drivers

INTRODUCTION

Almost 90% of US drivers rate themselves safer and more skillful than average. Obviously, such perceptions do not reflect reality. After all, nine out of 10 people can’t all be above average. Nevertheless, the results are compelling: They illustrate an innate human tendency to overrate our own talents and skills and underrate those of others.

Equity mutual fund managers likely have a similarly distorted view of their ability to generate alpha by outperforming the stock market. Otherwise, how would they justify their jobs?

But perhaps we’re missing the point. Maybe most drivers do drive safely and most fund managers outperform, with only a very few accounting for a disproportionate share of traffic tickets and accidents and major capital losses, respectively. Unfortunately not. The majority of fund managers do underperform their benchmarks: Only 17% of US large-cap mutual fund managers beat the S&P 500 over the last 10 years, according to the latest S&P SPIVA Scorecard. Moreover, there is no consistency among those few who did outperform. This all implies that successful manager selection is almost impossible (read Alpha Generation: The Search for the Unexplainable).

But research shows that factors rather than skill explain out- and underperformance. Therefore, outperformance and alpha are not exactly the same thing. So, how do we explain the difference?

OUTPERFORMANCE

While fund managers emphasize their ability to create alpha for clients, fund factsheets compare their performance to a benchmark. For example, the Invesco S&P 500 Pure Value exchange-traded fund (ETF, RPV) generated a return of 0.7% over the last 12 months, while its benchmark, the S&P 500, yielded –10.2%. The S&P 500 Value index might be a better point of comparison for RPV, but relative to the broad index, the ETF has delivered significant value — pun intended — to its investors (try Fin