Alpha is an important metric for investors to use when it comes to deciding whether or not to use an active or passive vehicle, however, data from FE Analytics shows that it can often be difficult to generate.
Passives usually benefit from lower fees but active managers can be more nimble and should have the ability to outperform the benchmark, providing better returns and offsetting the higher costs.
As the below table shows, on average, funds in the IA UK All Companies, North America, Global, Emerging Markets and Japan all failed to generate alpha against their relevant benchmarks over the past decade.
Average IA sector alpha generation vs relevant benchmark over 10yrs
Source: FE Analytics
In contrast, UK smaller companies and equity income funds, as well as European and Asia ex Japan funds managed to provide additional returns over the last 10 years.
Ryan Hughes, head of fund selection at AJ Bell, said: “It should be easier to deliver alpha in a market where there is a high level of dispersion between returns of the components of the index. It also helps if the index is more fragmented and not dominated by a few large companies.”
“This certainly would explain why it has been so hard to deliver consistent alpha in the US historically and also explains why alpha is evidenced when you look at managers further down the cap scale.”
Below, FE Trustnet looks at some of the more surprising results and asks industry experts why some sectors have successfully managed (or failed) to generate alpha.
The worst sector for alpha generation is the IA Global sector, where the average fund has returned 1.34 per cent less than the MSCI World over the past decade.
Hughes (pictured) said: “Despite global funds having an enormous universe of stocks to choose from, in reality, the index is dominated by large cap stocks, notably in the US.” 
“With the US being such an efficient market, and it being a dominant performer since the financial crisis, this has made delivering alpha in a global context challenging.”
“If we see other major market start to outperform the US, then it is conceivable that this alpha generation picture may change.”
Also underperforming is the IA Global Emerging Markets sector average fund, where many suggest active managers should outperform given the lower amount of research available on the market.
Hughes said: “Over the last decade, emerging markets have become a more disparate group as they have shifted from being a ‘beta’ play to an ‘alpha’ play.”
“In my view, this has made it significantly more challenging to outperform the broad index to the extent that I now think about these markets as individual regions i.e emerging Asia, Latin American etc rather than a collective group.”
“With such different drivers in these regions, I think we are seeing the emergence of specialist managers for each of these regions rather than the generalists of the past that have tried to cover the entire classification.”
Indeed, the average fund in the IA Asia ex Japan sector have outperformed the MSCI Asia ex Japan by 0.42 per cent.
More surprisingly however is the IA UK All Companies sector, where the average fund has failed to generate more alpha than the FTSE All Share index over the last decade.
Hughes said: “I’m a little surprised to see that the UK All Companies sector has negative alpha over this time period given the strength of the mid-cap outperformance.”
“So many managers have been overweight mid-cap and underweight large cap that I would have expected to see positive alpha coming from them.”
However, while these sector averages are interesting, Hughes says alpha should not be looked at as the only metric required to make an investment decision.
“We look at alpha when making decisions but this is just one metric,” he said, adding that looking at the alpha they have delivered “gives me an idea of skill but this is of course backwards looking”.
“I prefer to use a qualitative approach that is then backed up by quantitative analysis as I’m a strong believer that investing is an art not a science.”
Steve Lennon, investment manager at Parmenion, added: “Whilst investors in active funds clearly seek alpha, Parmenion believe that the risk achieved to achieve that outperformance is extremely important.”
“We believe that it is not necessarily true that ‘high alpha’ funds need to be higher risk than the peer group.”
“Therefore, we concentrate on seeking out funds which have not only delivered alpha but have done so with less volatility than the peer group. In addition, we pay close attention to the consistency of information and Sortino ratios to ensure that risk adjusted returns have been consistent over time.”
He adds that there is a “real danger” of attempting to draw conclusions from the average fund, as investors could miss out on some of the highest returning funds.
“The problem is that some sectors are incredible broad in terms of fund mandates and manager styles. This means that the average may well not be a fair reflection of the funds which investors are buying in the main,” he said.
As a result, in an upcoming series FE Trustnet will drill down into some of the more interesting sectors from the table to see where there has been the biggest dispersion between funds as well as other reasons why they have outperformed/underperformed their benchmarks.