Message To Active Managers: ‘Alpha Potential Always Exists’

Late last month, while revisiting the idea that US equities are a “perpetual motion machine” powered by passive flows and factor crowding, I mentioned the bleak prospects for active management.

Commenting on extreme concentration in the top 10 names, I presented the stark choice facing PMs: Either you pile into the same names, only with leverage, or you underperform.

It’s nearly impossible, I suggested, to beat an index that consistently returns 20% (or more) annually, especially when there are multiple exchange-traded products that allow you to track that index for just a few basis points. A quick look at a simple chart showing the annual gain for the S&P over the post-financial crisis era tells the story.

Read more: Howard Marks’s ‘Perpetual Motion Machine’ In The Pandemic Era

In the same linked article, I noted that according to JPMorgan, just 40% of Large-Cap funds outperformed through mid-December, and that actually counted as an improvement from 2020, when 70% missed their benchmark.

In a new note, Goldman’s David Kostin addressed virtually all of these issues at some length, starting with market concentration and the read-through for active managers.

“Narrow market breadth does not mean lack of opportunities,” Kostin said, noting that although return dispersion — “what matters for stock pickers” —  was “only modestly below average,” active managers performed particularly poorly last year. In other words, the scope of underperformance wasn’t excusable by reference to a dramatically diminished opportunity set.

Goldman’s cadence wasn’t particularly forgiving. “Alpha generation potential from stock-picking always exists, regardless of the broader macro environment,” Kostin remarked, before driving the point home. “The annual stock-picking opportunity set is always robust, ranging from 44 pp to 265 pp during the past 35 years,” he said, referencing the figure on the left (below).

The problem, Kostin wrote, is that “capturing alpha is extremely challenging [and] consistent outperformance requires remarkable skill.”

If active managers still possess such skill, it wasn’t on display last year. Just one in five Large-Cap Core mutual funds outperformed the S&P 500 on Goldman’s count, nowhere near the 32% historical average. Only 15% of Growth funds managed to best the Russell 1000 Growth index, less than half of the long run average.

Hedge funds, meanwhile, didn’t fare particularly well either. They’re a multifarious lot and as such are a bit harder to “indict” (if you will), especially given they don’t benchmark to the S&P. Still, equity long/short funds’ 12% gain in 2021 paled in comparison to the broad market’s return, while macro funds actually notched a losing year, albeit just barely.

You might suggest it’s the macro — when everything depends on the same set of macro factors, an already challenging task (capturing alpha) becomes virtually impossible. And yet, as the figure on the right (above) suggests, that wasn’t the case in 2021.

At the onset of the pandemic, “the macro contribution to the return for the median S&P 500 stock spiked to nearly 80%” leaving just 20% to idiosyncratic, firm-specific factors, Kostin said, before noting that although the macro still explained 48% of median stock returns in 2021, that was just barely above the long-term average.

Somehow, it feels appropriate that this discussion made the rounds on financial media outlets on a day when Apple’s market cap topped $3 trillion and Tesla rose 14%, its largest gain since March.