Why Active Fund Managers Can Outperform Digital Markets
In traditional markets, actively managed funds are struggling to outperform their benchmark indices. In digital markets, higher information asymmetries create more opportunities to trade for alpha.
According to Morningstar, sometime this year, assets in passively managed U.S. equity funds are going to surpass assets in actively managed ones.
The success story of Exchange Traded Funds (ETFs) — funds that simply mirror an index without any active portfolio management — had begun back in 1975 when Vanguard founder Jack Bogle launched the first ever ETF.
Since then, ETFs have quickly gained in popularity. They come with lower costs and most actively managed funds have failed to outperform the market over the past decade. Only 24% of all active funds topped their benchmark index over the 10-year period ending in December 2018. So why bother paying for fund managers?
Every monkey can beat the market
Princeton University professor Burton Malkiel claimed in 1973 that “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
He was wrong. They did even better.
Research Affiliates had 100 monkeys throwing darts at the stock pages each year from 1964 to 2010. The average monkey outperformed the index by an average of 1.7 percent per year since 1964.
Sounds bananas? Not really. As the monkeys picked stocks randomly, their portfolios on average included more smaller company stocks compared to the overall index. Small caps have outperformed the market over this period of time, so the monkeys fared better than the index.
Small caps come with higher returns, but also higher risks. There is no free lunch, not even for monkeys. When investing in small caps there are higher information asymmetries, as information doesn’t travel as efficiently as in large-cap markets and is often not published publicly. That creates opportunities for informed fund managers to outperform the market.
In large-cap markets, on the other hand, with increasing transparency and machine-based high-frequency trading based on artificial intelligence, the days of excessive returns from market managers are mostly gone.
Digital markets: a playing field for alpha hunters
Digital markets are somewhat similar to small cap markets. As information asymmetries are significant and market infrastructures are inefficient, there is more chance for astute fund managers to generate alpha and beat the market.
Besides that, digital assets investing is still in its infancy, and many don’t understand the technology and thus shy away from digital markets altogether. The high knowledge barrier creates opportunities to reap a “knowledge premium” for those who have the expertise.
Inefficient market infrastructure creates another opportunity for fund managers. Exchanges are not interconnected, and liquidity levels vary significantly across exchanges. INVAO deploys AI-based high-frequency trading algorithms to capitalize on arbitrage opportunities across exchanges. Leveraging arbitrage trading also decreases our portfolio’s exposure to excess volatility, as increases or decreases in price are irrelevant for the profitability of cross-exchange arbitrate trading.
In the meantime, the first digital asset ETFs have emerged, and there is another one coming up every other week. However, it will take a long time until digital markets reach the maturity of large-cap equity and bond markets in terms of liquidity and market efficiency. Until that happens, actively managed funds have an excellent chance to consistently outperform their benchmark indices.
And if they don’t, maybe walk down to the zoo and get yourself a monkey. Although that is likely to come with its very own set of challenges.
