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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
I
69
Source: SPIVA Scorecard, Year End 2011
In essence, Fama’s and French’s work indicated that looking
at the market was too broad a benchmark when evaluating
a manager’s portfolios and performance. By their nature,
some combinations (small cap/high book to market value)
would naturally have higher returns than other combinations
(large cap/low book to market value). The research led
to the tendency to compare a manager’s performance to
a benchmark that more accurately reflected the market
segment in which the manager was investing.
When managers and their portfolios were broken down to
a suitably discrete grouping, Fama and French were able to
prove that managers’ returns actually showed very little room
for positive tracking error (or excess performance) and that
active long-only managers only rarely beat their benchmark.
As a result, investors no longer compared a manager’s
performance to a total market index such S&P 500. They
began to assess and compare managers’ performance against
the index that was more representative of the market area
in which a manager was invested. For example, they began
comparing a manager that primarily invests in small and
emerging technology companies to a small-cap, growth index.
Once Fama’s and French’s work began to take hold, there was
rapid growth in the creation of indices. For equities, indices
were originally created to replicate nine major equity style
boxes based on two axes. One axis was based on the market
capitalization of the companies using three ranges: large,
mid, and small. The other axis pivoted on company valuation
related to its price, divided into three ranges: value, blended,
and growth. Fama’s and French’s work also applied to the
bond markets and led to the breakdown of default likelihood
into the categories of investment grade and high yield, and
then a breakdown of duration into short-term and long-term
bond holdings. Both equity- and credit-oriented indices
began to proliferate based on these new categorizations.
December
2001-06
57.18%
MID CAP
SMALL CAP
LARGE CAP
Growth
Value
Core
80.20%
December
2006-11
December
2001-06
75.43%
December
2001-06
90.74%
December
2001-06
88.06%
December
2001-06
75%
December
2001-06
75.53%
December
2001-06
91.98%
December
2001-06
76.47%
December
2001-06
57.18%
67.93%
December
2006-11
90.7%
December
2006-11
85.64%
December
2006-11
86.87%
December
2006-11
75.58%
December
2006-11
36.71%
December
2006-11
62.65%
December
2006-11
71.43%
December
2006-11
0% - 33.3% 33.4% - 66.6% 66.7% - 100%
Chart 4
Chart 40: Percent of Time that Indices Outperformed Active Funds
Chart 3
Size
Value
Total Market
Small
Cap
Large
Cap
High
Book
to
Market
Increase
Expected
Returns
Decrease
Expected
Returns
Low
Book
to
Market
Chart 39: Relationship Between Risk Factors &
Expected Return in the Equity Markets
Source: Fama & French as presented by Index Fund Advisors