North America
Quantitative Insights
When do enhanced indexation managers add alpha?
Ingrid Tierens
New York: 212-357-4410
Originally published:
October 15, 2003
Updated: March 1, 2004
In previous papers, 1 we identified market circumstances that seem to have a positive
influence on the ability of active equity managers and hedge fund managers to add
alpha. This paper presents an extension to this research for enhanced indexation
managers. We find that:
•
Enhanced indexation managers generated more alpha in momentum-driven and
small-cap tilted markets.
•
The importance of the momentum factor has increased through time.
Positive performance on average before fees, negative performance after fees
To analyze enhanced indexation performance, we used monthly returns from January
1990 to February 2004 for a representative basket of enhanced indexation mutual
funds benchmarked against the S&P 500. 2 We converted the monthly net-of-fees
returns 3 to monthly gross-of-fees returns by adding back 1/12th of the current expense
ratio of each fund. 4 The distribution of gross-of-fees alphas across all enhanced
indexation funds seems normally distributed and centered around zero basis points
per month (Exhibit 1).
Exhibit 1: Performance of enhanced indexation mutual funds covers a wide range
(Monthly data from January 1990 to February 2004)
35%
Average Monthly Excess Return
-6.9 bps (net-of-fees)
-0.1 bps (gross-of-fees)
30%
25%
20%
Net-of-Fees
Gross-of-Fees
15%
10%
5%
0%
-4
-3
-2
-1
0
1
2
3
4
Monthly Return in Excess of S&P 500 (%)
Source: FAME Information Services, Standard & Poor’s, Bloomberg and Goldman Sachs estimates.
1
When do active equity managers add alpha?, Joanne M. Hill and Ingrid Tierens, Updated March
1, 2004 and When do hedge fund managers add alpha?, Sandy Rattray and Venkatesh
Balasubramanian, Updated March 1, 2004.
2
The basket consists of enhanced indexation funds benchmarked against the S&P 500 index, and
represented approximately $8.7 billion in assets under management at the end of 2003.
3
Our study on active equity manager alpha used quarterly gross-of-fees returns for institutional
core, value and growth managers in the Russell equity manager universe. Here, we use monthly
net-of-fees returns for enhanced indexation mutual fund managers.
4
We, therefore, implicitly assume that the expense ratio has been constant throughout the life of
each fund. The median expense ratio for the funds in our basket is 99 bps per annum.
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Exhibit 2: The median enhanced indexation fund marginally outperformed on a grossof-fees basis (Monthly data from January 1990 to February 2004)
100
Jan90Dec96
Jan90Feb04
Jan90Feb04
Average
+ 1 Std.Dev
Jan97Feb04
Median Manager vs. Benchmark (mthly ret in bps)
Jan90Dec96
Jan97Feb04
50
Average
0
1
-4
4
-7
-50
10
-1
Average
- 1 Std. Dev
GROSS-OF-FEES
NET-OF-FEES
-100
43%
44%
49%
42%
50%
49%
% of Months > S&P 500
Source: FAME Information Services, Standard & Poor’s, Bloomberg and Goldman Sachs estimates.
What market environments seem advantageous for enhanced indexation managers?
The common intuition that active managers tend to perform better in down markets
does not hold up for enhanced indexation managers. While we found a significantly
negative link between manager alpha and market returns for active institutional equity
managers, the alpha generated by enhanced indexation managers does not bear a
significant connection with market direction (Exhibit 3).
Exhibit 3: Median enhanced index manager performance does not seem to be driven
by market direction (Monthly data from January 1990 to February 2004, net-of-fees)
250
Monthly Median Manager Outperformance (bps)
200
-15
150
100
50
0
-10
-5
0
5
10
15
-50
-100
-150
Insignificant relationship
-200
-250
Monthly S&P 500 Index Return (%)
Source: FAME Information Services, Standard & Poor’s and Goldman Sachs estimates.
2
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Exhibit 4: Factors used to explain relative performance of enhanced indexation managers
Cash-drag
Small-cap tilt
Cross-stock
dispersion
Style dominance
Momentum
Proxy for Factor
S&P 500 Treasury Bill Return
S&P 600 S&P 500*
S&P Value S&P Growth
Ratio of Stock to
Index Variance
High 11-Mth Price
Return - Low 11-Mth
Price Return
Expected Impact on
Manager Excess
Return
-
+
+
+
+
*Note: Russell 2000 - S&P 500 before inception of the S&P 600 index (January 1994)
Source: FAME Information Services, Standard & Poor’s, Ibbotson Associates, Fama / French and Goldman Sachs estimates.
To identify market environments that might improve the ability of enhanced indexation
managers to beat their S&P 500 benchmark, we focused on the same set of market
drivers we used for the active institutional equity manager universe. Exhibit 4
summarizes these factors, the proxies we used to quantify them, and their expected
impact on alphas. 5
As some of the factors tend to be highly correlated, we performed a stepwise regression
for the median fund return, both before and after fees. Our analysis suggests that the
largest contribution to enhanced index alpha has come from momentum, followed by
small-cap tilt (Exhibit 5). A comparison of the first half of the sample (1990-1996)
with the second half of the sample (1997-2004) shows that momentum has become
the main market-wide driver in the second half of the sample, while small-cap tilt was
the only relevant factor earlier on. Our selection of market-wide factors explains about
one quarter of the variation of median enhanced indexation alpha.
Exhibit 5: Momentum has become a more important performance driver for enhanced indexation alpha
(Monthly data from January 1990 to February 2004)
A. Net-of-fees
Adj R-square: 25%
B. Gross-of-fees
Adj R-square: 42%
-90 bps
50
-40 bps
12 bps
0
1990-1996
-50
-100
150
Adj R-square: 30%
1990-2004
Adj R-square: 25%
Adj R-square: 42%
Adj R-square: 29%
110 bps
Average Annualized Contribution (bps)
Average Annualized Contribution (bps)
100
100
-5 bps
52 bps
50
0
1990-1996
-50
1990-2004
1997-2004
-100
-150
1997-2004
Momentum
Small-Cap Tilt
Intercept
Momentum
Small-Cap Tilt
Intercept
Source: FAME Information Services, Standard & Poor’s, Bloomberg, Fama / French and Goldman Sachs estimates.
5
For a motivation for each of these factors, see When do active equity managers add alpha?,
Joanne M. Hill and Ingrid Tierens, Updated March 1, 2004.
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Corresponding r-squares for traditional institutional equity managers were noticeably
higher (between 40% and 60%). The lower r-squares indicate that even though the
overall market environment has some impact on the ability of enhanced index
managers to beat the S&P 500, idiosyncratic rather than market-wide factors appear
to be the main drivers.
Looking at the funds on an individual basis, we find that momentum plays a significant
role to explain the alpha of about two-thirds of the funds. Our basket of enhanced
indexation funds does not include enhanced index managers who predominantly use
non-equity instruments or derivatives to add alpha. We found that the alpha of those
funds was not influenced by any of the factors we examined.
Conclusion
While the alpha of institutional active equity core and value managers, as well as
long/short and market-neutral hedge fund managers, seems to improve when dispersion
across stocks is high, the alpha of enhanced indexation funds appears to be mainly
driven by momentum in the market. Small-cap tilted markets improve enhanced
indexation alpha as well. These alpha drivers could potentially indicate biases
embedded in the investment processes of the “typical” enhanced indexation manager.
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