Do Less Efficient Markets Lead to Higher Alpha?

Introduction

Many students seek career advice in finance, but the global capital markets are becoming increasingly efficient, making it harder for fund managers to generate alpha. While some believe that focusing on less efficient markets could lead to higher alpha, the reality is that even in these markets, fund managers struggle to outperform their benchmarks.

In the investment world, fund managers are expected to be able to extract alpha, or excess returns, from the markets. However, the reality often falls short of this expectation. So how have fund managers performed in less efficient stock markets?

Alpha Generation in US Equity Markets

Research on US equity markets shows that the majority of fund managers fail to beat their benchmarks. According to S&P’s SPIVA Scorecards, 82% of US large-cap mutual fund managers failed to beat their benchmarks over a 10-year period from 2010 to 2020. From 2000 to 2020, an astonishing 94% of managers failed to do so. Even US small-cap fund managers did not fare much better, with 76% underperforming their benchmark in the last 10 years.

Specialist knowledge in sectors such as real estate should theoretically offer rich alpha opportunities. However, 76% of REIT fund managers also couldn’t beat their benchmarks, indicating that even these markets are too efficient in the United States.

Exploiting Less Efficient Markets

Emerging markets are often perceived as less efficient and offer potential alpha opportunities due to higher information asymmetries and domination by retail investors. However, the performance of fund managers in both developed and emerging markets is disappointing. In developed markets, 74% of equity fund managers underperformed their benchmarks in the three years ending 2020, compared to 73% for emerging market fund managers.

Extending the observation period to five and 10 years does not improve the perspective. In emerging markets, 84% of equity fund managers underperformed their benchmarks over the last five years, compared to 80% for their developed market peers. Over the last 10 years, the underperformance rate increased to 85% for emerging market fund managers and 82% for their developed market counterparts.

Performance Consistency

The lack of alpha generation from mutual fund managers is not a new phenomenon and has been flagged by academic research for decades. The consistency of performance among fund managers is also a concern. In the US equity mutual fund space, only a small percentage of top-performing funds managed to stay in the top quartile in subsequent years.

Emerging markets show some performance consistency in the following year, but it quickly declines in subsequent years. This suggests that even the best-performing funds lack a competitive edge across stock markets.

Emerging Market Hedge Funds

Even in emerging market hedge funds, which are relatively unconstrained and can go long and short equities, bonds, and currencies, outperforming benchmarks remains a challenge. The return of the HFRX EM Composite Index since 2012 has essentially been zero, indicating a lack of alpha.

Further Thoughts

The inefficiency of emerging markets stems from larger information asymmetries compared to developed markets. However, fund managers still struggle to take advantage of these opportunities. Stock picking is difficult regardless of the market, and the risk also increases in less efficient markets. The ability to forecast is limited, and emerging markets are inherently unstable.

Instead of focusing on less efficient stock markets, investors may find more opportunities in private markets like private equity and venture capital. These asset classes offer complexity that is difficult to benchmark, creating a potential edge for asset managers.