Alpha is the excess return above a risk appropriate benchmark return that a fund manager might achieve over a period of time.
The three key factors at play here are; the average excess return achieved, the variability of the excess return above the benchmark and the number of years of data in a given study.
For any fund we can determine if a series of historical returns is reliably superior to a risk-equivalent benchmark by applying a t-test.
The t-test was introduced in 1908 by William Sealy Gosset while working for the Guinness brewery in Dublin to evaluate the quality of the brewery’s ingredients.
In investing, the t-test can be used to determine whether any market beating returns are due to luck or skill. When we apply a t-test to the historical performance we get a statistical feel for how significant the results are.
A result from a t-test in excess of 2 is widely accepted to be a measure of statistical significance.
When we apply a t-test to the results of any particular fund we should always start with a "null hypothesis" that is to say that we don't believe a fund manager has any skill and we should set out to statistically attempt to disprove this proposition.
Here is the difficulty with this process. At any given time we have the existing track record of any given fund manager, the average excess performance he has achieved and we can measure the volatility of that excess performance compared to a risk appropriate benchmark. But the limiting factor here is the career of the fund manager. We actually don’t get that many observations of their decisions.
In another post, I recently pointed out that if I flick a coin 5 times and it comes up heads 5 times, there is a 3% chance that will happen just by luck. So, by the same token, 5 years of performance for a fund manager isn’t sufficient time for us to say with a high enough degree of confidence that here is the “Tiger Woods of fund management”.
We need at least 30 or 40 years of data to show statistically that, yes this fund manager has real skill above the market, allowing for the risks taken, and the persistency of the results is consistent enough to believe that they are really skilled.
So, what do we do if we only have say 5 or 10 years of results for a fund?
Well, we know the average returns, we know the benchmark and we can calculate the variability of the alpha. So, we can extrapolate how many years of results we would need to achieve a statistically significant t-statistic. In other words how long we would have to watch the fund manager to be able to say, yes this guy has real skill and it isn’t just luck so it’s ok to invest here.
So, turning to the fund mentioned in the initial post. It just so happens that our friends in Orange County California have looked at this exact question for this exact fund. Their findings:
“Two funds that have recently received attention from the financial media are the Yacktman Fund and the Yacktman Focused Fund, both managed by Donald and Stephen and Yacktman. From the average alpha and variability of the alpha, we have calculated that we would need 105 years of similar returns to conclude the presence of skill. For the Yacktman Focused Fund vs. the Russell 1000 Value Index, the average alpha was -1.10%, so there is no number of possible years to conclude the existence of skill.”
So, there is no evidence of skill in these funds that would lead us to believe that we should invest our capital in them. We might be willing to wait 105 years just on the off-chance that we are wrong, but of course by then we will all be long dead.
The conclusion reached time and time again. When you correctly account for the risks taken MOST fund managers do not have any independently verifiable skill, and those that might do not appear to have enough skill to compensate for their costs.
It might be the case that a fund manager picked at random (and believe me speaking as someone who spent the first 10 years of their career actually doing this, picking fund managers at random is all you are really doing here) will turn out to beat the market. But I can’t be sure before I invest TODAY that that is going to be the case in the FUTURE, as I almost never have enough of a track record to be able to make that call.
By the time a fund manager’s skill comes to light, it is basicially too late for anyone to profit from it now. Think about Anthony Bolton at Fidelity. He had an amazing track record. But I have asked literally thousands of investors over the years if they invested in the Fidelity Special Situations fund at the start back in 1979 or 1980 or 1981. Never met a single one! By the time I was advising clients in the early 1990s Anthony Bolton was coming up on retirement!
I have also met Neil Woodford on many occasions when I worked in the UK. He was nearly sacked by Invesco Perpetual for refusing to buy Tech stocks in the late 1990s as his value driven Income fund significantly underperformed.
Once again, we need to correctly account for the sources of his returns by applying a multi-factor analysis (sensititvity to the UK Market, sensitivity to small vs large companies and sensitivity to value vs growth). He is a value investor so what I want to know is how much alpha does he generate over and above a UK Value index, and secondly is it enough to compensate for the higher fees and expenses of running an actively managed fund? Finally, as the fund grows, is it possible for the excess performance to persist? Again, all the evidence suggests that it simply isn't possible to do this - although arguments rage over why.
Remember our capital – very plentiful. Skilled fund managers – thin on the ground.
A central tenant of economics is the scarce resource captures the rent! In this scenario if there is any skill on the table it is the fund managers who profit not the investors.
