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Historically less than 50% of investment managers have succeeded in producing consistent long-term alpha for their clients. In recent years that number has been dwindling significantly, and overall alpha across the entire investment industry has been falling. The consequence is a significant trend of capital moving from active investment strategies to passive investment alternatives. Passive alternatives are exchange traded funds (ETFs) and other similar, highly diversified factor portfolios that exactly or nearly track benchmarks. Today, allocators are questioning the value of active investment management and re-embracing many of the efficient market hypothesis beliefs developed in the 1970s. Whether it be new automated security selection technologies or factor investing designed to manage capital on a diversified risk-adjusted basis, belief in the value of fundamental active management is waning.

During my 87 years I have witnessed a whole succession of technological revolutions. But none of them has done away with the need for character in the individual or the ability to think.

—Bernard Baruch, investor

There are certainly situations in which passive investing is the best alternative. For most individual non-sophisticated investors, passive alternatives are clearly the best option. This book is geared toward professional investment managers and capital allocators interested in learning and honing the craft of active management. For this group of dedicated investment professionals alpha creation is very possible. One caveat is that alpha creation is harder in some markets than others and strategies must match expectations. Large cap investing in the US is a more difficult universe to create alpha in than small cap emerging market investing. Managers must understand both the potential and limits to their unique strategies and build their investment process on their investment goals.

There are many indices and specific methodologies by which to measure hedge fund alpha over time, and specific time periods have unique market issues, but the overall downward trend is undeniable. Figure 1.1 provides 30 years of hedge fund return data. The trend line is clear and the last decade demonstrates the pressures on the core investment tenets and decision-making that we will be discussing.

The result of the poor performance has been very poor net asset flows into hedge funds, which puts short-term pressure on hedge fund managers to perform well or risk having to close their firm. Figure 1.2 shows that it is clear that attracting capital for hedge funds has been very difficult during the 2010s. The ten years prior to the financial crisis saw a net $665 billion go into hedge funds. The financial crisis caused large outflows totaling $275 billion, which is not uncommon during times of stress. However, from 2010 to 2019, net inflows to hedge funds totaled only $105 billion. This is not only five times less than the ten-year period prior to the financial crisis but it is reclaiming less than half of the assets that were withdrawn during the crisis.

This is not an issue specific to hedge fund managers alone or an indictment of the hedge fund industry in any way. This is central to all active investment managers trying to outperform the market over the last decade. Not only has alpha been dropping, the percentage of managers who outperform at all has been dropping. Figure 1.3 demonstrates the drop in the percentage of active managers outperforming the S&P 500 on a five-year average return basis. Until the 2010s the percentage of managers outperforming was in the mid-to-high 40s, but since 2010, it has dropped to the low-30s range.

FIGURE 1.1 36-month rolling alpha of the HFRI Fund of Funds Composite Index

Source: Hedge Fund Research (HFR).

FIGURE 1.2 Net asset flows into hedge funds

FIGURE 1.3 Percentage of US equity funds that beat the S&P 500 (five-year average)

The mutual fund industry is monitored separately, and the majority of mutual fund managers have underperformed their benchmarks after fees consistently for decades. In an analysis completed in June 2019 by the S&P Indices Versus Active (SPIVA) project, only 21% of large actively managed US mutual funds outperformed the S&P 500 over the previous five years. Additionally, research performed by both Vanguard and Morningstar showed 90% of large cap US mutual funds failing to outperform the S&P 500 from 2001 through 2016.

The recent market environment has not had as pronounced a negative effect on cash flows into the mutual fund industry simply because the average mutual fund manager in the 2010s focused on tracking error (volatility around their benchmark) and diversified away both the ability to outperform or underperform the market materially.

The challenges of the current environment will remain for a long time, and only a disciplined process designed on the core investment tenets that create outperformance will enable managers to be successful. Competent capital allocators can find alpha-producing managers to enhance their returns through a thorough due diligence process and an understanding of the alpha potential for different strategies and the pieces that need to be in place for a manager to outperform the market. Again, not an easy task, but it is achievable. Endowments, foundations, and family offices have the long-term track records demonstrating the significant value added from partnering with alpha-creating active investment managers.

In an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

—Eugene Fama, economics professor and Nobel laureate

Re-embracing the beliefs of the efficient market hypothesis is understandable from an allocator's perspective when outperformance falters the way it has in the 2010s. However, the theory is often misunderstood and misused in the debate over active and passive investing. Many people define the theory as, you can't beat the market. Nowhere does it actually say, no one can beat the market. The theory put forward by Eugene Fama states there are three forms of the efficient market hypothesis (EMH): strong, semi-strong, and weak. These forms vary in strength of theoretical statement on markets being efficient and offering the potential of outperformance, but most important it is based on the concept of average active investment returns. There are investment managers who can and have outperformed the markets. Historically, the extent of the outperformance by investment managers is dependent on strategy (geography, sector, market cap size). Although one in five experienced managers may outperform consistently over time in the US large cap space, closer to one in two managers outperform in niche sector markets or markets outside the US. It is important to understand what an average performance will achieve, but equally important to strive and prepare to be above average.

If I subscribed to the efficient market theory I would still be delivering papers.

—Warren Buffett, investor

Espousing the theory of efficient markets and moving capital to passive alternatives has an additional benefit to capital allocators: job security. No capital allocator ever underperformed the market by being in passive alternatives. From a career perspective moving to passive investing is a very low risk decision, especially when everyone else is moving the same direction. Expectations and the pressure to outperform are lower for chief investment officers if clients and fiduciaries believe that active investing cannot produce alpha. Past failures to produce alpha through active manager selection can be written off as an industry failure, not an individual capital allocation firm failure. A move to passive investing will drop expectations to a level that will always be met. No alpha expectations from clients, constituents, and board members will mean no underperformance (hence no stress) by the chief investment officer and investment team. The outcome, of course, is that they have now, also, given up any chance of outperforming.

It is very clear from my own investing and watching other active managers that outperforming the market, although difficult, is possible. Unfortunately, the 2010s were particularly difficult, and many of the best managers in the world have struggled to produce returns. Large established hedge funds have closed their doors in frustration. Efficient market theorists may point to enhanced communication via the internet, quantitative models, and fair disclosure laws as limiting factors, but there is another answer behind the recent alpha degradation.