Research suggests some managers have the skill to produce long-term alpha before fees, but the cost of producing this alpha is too high, resulting in net alpha that is typically negative. The “paradox of skill” is that as the skill and quality of the analysis of investment professionals has risen, the ability to produce strong excess returns of yesteryear is much more difficult. Put simply, competition has intensified. In fact, the world is moving towards a winner-take-all competitive dynamic because of globalisation. The rewards of winning accrue to a few businesses, whilst most industry participants end up producing average quality products and as a result are in various stages of economic failure.
Low fees and trading costs can reduce this alpha hurdle and improve the probability of translating gross alpha into net alpha. It is only net (after fees and costs) alpha that is relevant to clients, because this is the return they receive. Mauboussin suggests that costs are a key factor in separating the best performing from worst performing funds. The Hyperion Global Growth Companies Fund (Managed Fund)3 has a base management fee of 70bps p.a. We believe this fee is lower than most of our peers. A performance fee in the Hyperion Global Growth Companies Fund (Managed Fund)  of 20% of outperformance against its benchmark ensures Hyperion only enjoys higher fees when the unit holders also do well. That is, the performance fee structure helps improve the economic alignment of Hyperion with client investment return outcomes. The performance fee is subject to high water marks and is only payable on positive absolute returns.
Hyperion’s stock portfolio turnover is typically in the 20% to 25% p.a. range. This level of portfolio turnover is well below both the market average and the average active fund manager that often approaches 100% p.a. Low portfolio turnover helps improve our clients’ after-tax and after transaction cost returns. This is in stark contrast to many active fund managers that have extremely high turnover because they are trying to chase short-term alpha. Chasing short-term alpha is extremely difficult to achieve successfully over long time periods and can be expensive in terms of after-tax and after-cost returns. The avoidance of over-trading is another way to lower the cost hurdles needed to produce net alpha. We believe we do some simple, logical things that increase our odds of out-performing. For example, we only change our portfolio weights in response to share price moves that we believe are meaningful and non-fundamentally driven.
Alpha is a zero-sum game where the winners (out-performers) are accruing returns at the expense of the losers (the under-performers). To outperform, the mistakes of others need to be exploited. Historically the “victims” were individuals or some poor performing institutional funds. However, investors that tend to perform poorly eventually give up. According to Larry Swedroe and Andrew Berkin in their book “The Incredible Shrinking Alpha,” U.S. households held more than 90% of U.S. corporate equity at the end of WWII. This declined to 48% by 1980 and 20% by 2008. Similarly, institutional funds have struggled to survive, and dollars have flowed to passive managers. Swedroe and Berkin also cite research from John Bogle who found that about 7% of mutual funds “died” each year between 2001 and 2012. This is supported by fund survivorship data from SPIVA (2021) that shows the number of active fund managers in their data sample sets declining by mid-single digits per annum over long time periods. In fact, over 7% of Australian equity general funds were liquidated in 2020, although this rate was higher than typical. In terms of the US Scorecard, between 5% to 10% of funds did not survive in 2020, consistent with recent years.
Evidence suggests the proportion of professional investors accruing alpha after fees is shrinking. Swedroe and Berkin referenced academic studies by Mike Sebastian and Eugene Fama that suggest that only the top 1% to 2% of funds showed statistically significant skill (alpha).
John Bogle (2018) highlighted the proportion of active managers who underperformed the market has increased over time. Further analysis from Verheyden et al. (2016), who developed a framework to assess whether participants successfully capitalise on market inefficiencies, found that not only are most funds “unable to outperform the market systematically,” but only a small sample can generate alpha and gains from inefficient markets. However, successful managers can manage drawdown periods well in market downturns and distress, as well as take advantage of when a market may return to equilibrium stability through what they call “learning effects maximisation.” History suggests Hyperion’s best alpha capture periods are through a crisis where markets dislocate such as the GFC and COVID-19.
In our first edition of “The difficult quest for long-term alpha after fees” (2018), we referenced Charlie Munger, who has been widely quoted over the years saying, “the top three or four percent of the investment management world will do fine.” We believe this now applies to hedge funds, where the performance of the average manager appears to have declined materially over the past decade. This is supported by Bollen et al. (2021) that documents a clear decline in performance since the GFC. Using an equal-weighted hedge fund index, they observe total cumulative returns of just 25% over the eight-year period from 2008 to 2016, a stark contrast from the 225% return for the ten-year period from 1997 to 2007.
It is likely that this decline in returns post the GFC at least partly relates to the fact that many hedge funds have a value style bias. Using Fama French data, Hyperion research indicates that value style managers have significantly underperformed since the GFC (refer Figure 2). Many hedge fund managers have a value style philosophy and investment approach. We believe a key reason why value style investing has performed poorly since the GFC relates to the lower economic growth environment and higher levels of globalised competition because of the internet and smart phones. It appears likely economic growth rates and inflation will remain low over the next decade. This is because of ageing populations, declining population growth rates, high debt levels, the hollowing out of the middle-class, increasing technology-based innovation and higher levels of natural resource constraints and disruption. In addition, the internet, smart phones and ecommerce will ensure continuing high levels of price-based competition. We believe a low growth, highly competitive and disrupted environment is likely to make it difficult for traditional value style investors and, therefore, most hedge funds to produce alpha over the long run.
Figure 2: Fama French HML Index updated for COVID-19 – Value Underperforms in Low Growth, Low Inflation, Low Confidence Environments