During the past two decades, the share of passively managed equity fund assets has risen. While some lament that passive investors have consigned themselves to merely average returns, the truth is that the market average has been pretty good. The excess return on U.S. stocks has been about 6.1% annualized since 1926. The market return is the baseline upon which we can judge the performance of any U.S.-stock fund. In fact, most of the movement of our funds can be explained by exposure to a broad market index, otherwise known as market beta. Any return that an active portfolio manager can deliver in excess of the return from beta is alpha.
For most funds, beta is the largest source of return. The expectation for return beyond that which can be obtained cheaply through beta could justify the higher fees that active managers charge. But from January 2011 through December 2014, beta sources provided 104% of the return to the average active U.S. equity fund. Even among the 39% of the active fund share classes that managed to produce non-negative alpha, beta sources contributed 89% of the return.
The traditional market beta from the capital asset pricing model (CAPM) indicates the extent to which a portfolio is exposed to the market. The portfolio return that is related to beta represents compensation for bearing market risk. But there are other betas. Many portfolio managers have found success by buying small-cap stocks, value stocks, high-quality stocks, and those with strong momentum. It turns out that these characteristics of individual stocks are systematically related to the risk/return profile of an entire portfolio.
Isolating Factors
By grouping stocks according to these characteristics, we can measure the return to the characteristic, or factor, itself. We can then use these factor returns to examine portfolios. Just as we can monitor our portfolios by looking at exposures to individual stocks, we can examine the exposure of our portfolios to these factors. Why these additional sources of return exist is not clear. They may be anomalies. They may represent compensation for bearing risk. Investor behavior could also play a role in their existence and persistence. Whatever their source, there is no guarantee that these factors will persist in the future, and they may be destined to be arbitraged away.
From 1957 through 2014, the average monthly return of the broad market in excess of the risk-free rate was 0.51% (table below). The table also shows the average monthly excess return from several factors. These represent the returns from going long a basket of stocks that exhibit high values of each characteristic and shorting a basket of stocks with low values. In addition, we break out a recent 48-month period which we will use to examine U.S. equity funds. The data are from AQR Capital Management.
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While the average return to each of these factors is positive over the longer time frame, they can be quite volatile. Small stocks (SMB) have beaten large caps since the tech bubble burst around 2000, but underperformed large caps from 2011 through 2014. Value stocks (HML) underperformed growth stocks during the most recent four-year period. Momentum (UMD) has shown the highest average excess return since 1957, yet it turned deeply negative coming out of the financial crisis as the market began to recover. Finally, the returns of high-quality (QMJ) stocks have been particularly strong in the wake of the financial crisis.
Beta Everywhere
We applied the multifactor model to all passive and active mutual funds and exchange-traded funds in the U.S.-equity category group. The chart below displays the contribution to total monthly return by all multifactor betas and by alpha for all 5,318 active U.S. equity fund share classes during the 48-month time period. Each fund's total monthly return, the sum from alpha and beta sources, is a column on the x-axis and is sorted by alpha.
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Sources: Morningstar, AQR Capital Management, and author's calculations.
The average monthly return of all active funds from all beta sources was 1.14%, while the alpha was negative 0.04% for a total return of 1.10%. Thus, beta sources provided on average 104% of active funds' returns during the time period. Even among funds that managed to avoid a negative alpha, where the average alpha was 0.13% per month, the beta sources contributed 1.08%, which is 89% of the returns on average. It is clear that the returns from all beta sources has provided the majority of these funds' returns.
Performance Evaluation Gets Smarter
The multifactor model used here is by no means perfect. The idiosyncratic risk of individual stocks is just too high for this model to be useful in assessing a concentrated portfolio. Not every quality stock will go up when the quality factor says that it should. In addition, the definition of value is simply book/market, so it does not take into account other ways to define value, such as with measures of earnings or cash flow. This model also assumes stable exposure to each factor, so a manager's ability to tactically time exposures is attributed to alpha.
What this approach does show is that performance evaluation is getting smarter. The tools we use to explain returns can be applied to any fund, and the outcome can inform our understanding and expectations of a manager and better gauge how he should be compensated. There is an expanding menu of low-cost ETFs and mutual funds providing exposure to these basic elements that constitute stock markets' return.
Active managers who can consistently deliver alpha should command higher fees. Active managers might seek alpha by allocating between the factors or by identifying individual security-selection opportunities. Yet, despite the attention alpha receives, beta is the most significant source of return for most funds.
