Although the popularity of index investing has exploded in the past decade, actively managed funds still make up the majority of investor assets.
Listen now and learn:
- How often active managers fail to beat the market
- Why managers that do win fail to keep winning
- Three key characteristics that deserve most of your attention
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Show Notes
Three of the last four episodes (EP. 70, EP.72, and EP.73) have highlighted the challenges of predicting and beating the market, so I thought it might be useful to look at the performance of professionals whose job it is to do just that.
But first, let’s define active management so that we’re all on the same page.
Active management is when a portfolio manager chooses investments deemed to be most attractive based on an independent assessment of their value. The goal is to outperform a standard benchmark index.
For example, an active U.S. equity investor might be seeking to beat the Russell 3000 and an active bond manager may seek to outperform the Bloomberg U.S. Aggregate Bond Index.
Active managers can seek to beat their respective benchmark by owning more (or less) of a security based on their independent assessment of its value. Another way active managers try to beat their respective index is by taking more (or less) risk than the benchmark.
A passively managed index fund, on the other hand, seeks to replicate the performance of the benchmark they are tracking instead than trying to beat it. And rather than picking and choosing which securities to own, a passively managed index fund simply owns all the stocks or bonds of a given market index in the proportion held within that index.
Active Managers Fail to Beat Their Benchmarks
Since first published in 2002, the S&P Indices Versus Active (SPIVA) Scorecard has served as a de facto measure of the effectiveness of active management versus indexing.
The SPIVA scorecard is released twice a year. Here is the most recent version as of this recording, which shows more than 91.79% of all U.S. Equity Funds trailed their respective benchmarks over the last 3-year period, 87.53% failed over the last 5-years, and more than 90% failed over the last 10-, 15-, and 20-year periods.
Global, International, and Emerging Market Funds didn’t fare much better, failing to beat their benchmark 80-95% of the time depending on the time period measured.
| Fund Category | 1-Year | 3-Year | 5-Year | 10-Year | 20-Year |
| All Domestic Funds | 65.29% | 88.49% | 87.53% | 91.79% | 93.10% |
| Global Funds | 75.45% | 84.48% | 83.75% | 90.52% | 87.83% |
| International Funds | 66.30% | 78.78% | 80.69% | 88.77% | 94.31% |
| Emerging Market Funds | 76.72% | 72.68% | 83.41% | 84.30% | 95.83% |
These results are not unique to this specific report or point in history. You can Google past years of the SPIVA report and find similar results. Obviously the numbers vary a bit year-to-year, but the one trend that seems to always stay intact is that underperformance rates rise as the time period being measured lengthens.
The thing that really stands out to me in the graphic is that there is a little bit of dispersion among failure rates in the short-term – even though the majority of managers fail – but over a 15-year horizon, more than 70% of actively managed funds failed to outperform their comparison index in 38 out of 39 categories.
The Winners Don’t Keep Winning
For those funds that do manage to outperform, history suggests they are unlikely to do so in the future.
Standard & Poor’s also releases a scorecard on the persistence of outperformance among active managers that yields some really important insights.
The latest S&P Persistence Scorecard released in April 2022 showed that “regardless of asset class or style focus, active management outperformance is typically short-lived, with few funds consistently outranking their peers or benchmarks.”
Much like you can Google past years of the SPIVA report, you can typically find PDFs of past Persistence Scorecards with a little bit of digging, and (again) you’ll find the results aren’t unique to this specific time period.
The insights from this report are especially important for people who scoff at the seemingly black-and-white nature of the active vs passive scorecard, with rebuttals such as “we only invest in the winners and best performers” or “we have a process to avoid managers that fail to beat their benchmark.”
The Persistence Scorecard tracks performance persistence in two ways.
The first is over three and five consecutive 12-month periods. In other words, how many of the funds that outperformed in one year went on to outperform the next two and four years?
Statistically speaking, the odds of a top-quartile fund remaining in the top quartile for the next four consecutive years is just 0.39% (25% x 4 = 0.39%). So the odds are heavily stacked against active managers in the first place.
But I’ll admit, the latest report shows that active managers within the Domestic Funds category defied those odds….but only to the tune of 1.66%. In other words, of the top performing U.S. equity managers in 2017, only 1.66% remained in the top quartile by the end of the five-year period.
Skeptics might think I’m cherry-picking data, but (again) you can Google past Persistence Scorecards and see that this failure rate is consistent throughout time.
The other thing the Persistence Scorecard tracks are two non-overlapping three- and five-year periods. This is actually my favorite set of data to use.
Looking at all Domestic Funds for non-overlapping five-year periods, this year’s report takes the group that outperformed for five years ending December 2016 and measures how they did over the next five years. The results were not that great: only 13.46% remained in the top quartile by the end of 2021.
Perhaps even worse, 73.71% of those top-quartile funds from the previous five-year period ended the next five-year period either in the bottom 50% of performers; or they had to merge, liquidate, or change styles – which anyone in asset management knows is basically killing the fund because it performed so poorly.
One final quote directly from the report that I think is worth sharing:
“While the persistence report does not prove that fund performance is completely random, from a practical or decision-making perspective, it reinforces the notion that choosing between active funds on the basis of previous outperformance is likely a misguided strategy.”
Why Does Active Management Fail?
For starters, active management tends to be more expensive than passive management because active managers need to pay for data, research analysts, and portfolio managers to choose the most attractive investments. They also typically have more trading costs associated with trying to take advantage of short-term price fluctuations.
Fund expenses come directly out of returns, so actively managed funds’ returns are at an immediate disadvantage versus index returns. That one is pretty straight forward.
As I mentioned at the onset of the episode, I’ve covered these reasons in greater detail in a few recent episodes, so I’ll do my best to briefly summarize these points:
- Episode 70: Thinking of Markets Like Piles of Sand explains how the stock market is a complex adaptive system in which cause and effect are not neatly linked because the emergent behavior of the millions of interacting participants and data points within financial markets are too complex to reliably predict.
- Episode 72: The Collective Wisdom of Financial Markets describes why it’s reasonable for most people to accept current prices as very close to accurate and active managers tasked with finding mispriced securities are pitting their own knowledge against the collective knowledge of millions of people.
- Episode 73: Why It’s Hard to Beat the Market with Dr. Andrew Berkin, we cover an array of reasons for why it’s difficult to beat the market, including Efficient Market Hypothesis (markets are very good at pricing in all available information to the point where any mispricing can’t be systematically exploited) and the Paradox of Skill (as the level of competition goes up, it gets more and more difficult to exploit others).
Active vs. Passive: An Incomplete Comparison
There will always be active managers that outperform the overall market, but it is extremely unlikely that any one person will identify managers that outperform in advance and consistently pick the best active manager for any given asset class.
The latter point is extremely important because the odds of your portfolio outperforming get progressively smaller as the number of funds in the portfolio increase.
You might conclude from this evidence that investors should only use index funds, which is far from being a bad conclusion, but also somewhat misses the mark.
The real comparison should be low-cost versus high-cost, low-turnover versus high-turnover, and a rules-based versus forecast-based approach. When you fall on the right side of these comparisons, you position yourself for better investment results.
Traditional active managers tend to be on the wrong end of these comparisons, while index funds are usually on the favorable side.
1. Low cost vs high cost
The importance of low investment costs was first highlighted by Nobel Laureate William Sharpe’s 1966 work on mutual fund performance, with several studies identifying a close link between cost and performance.
The higher fees that come with actively managed funds are well documented, but those fees are taken directly out of performance on a daily basis so you may never see them.
The impact is simple: the more you pay, the less you have in the end.
2. Low turnover vs high turnover
Equity funds with low turnover also have a distinct advantage over equity funds with high turnover.
Turnover measures the frequency in which securities are traded over a 12-month period and serves as a good proxy for trading costs within equity funds.
Active managers tend to trade more frequently in an attempt to add value, but trading costs related to brokerage fees, bid-ask spreads, and price impact can dramatically reduce a fund’s performance.
Evidence strongly suggests that equity funds with high turnover have lower rates of outperformance (turnover is a less useful metric with fixed-income funds).
3. Rules-based vs forecast-based
Most active managers attempt to identify mispriced securities or correctly time market movements.
Markets are complex adaptive systems, which makes predicting market movements nearly impossible. In addition, the ultra-high competition for capturing profits doesn’t leave much opportunity for outperformance to go around.
On the other hand, a rules-based approach doesn’t make predictions about the direction of markets. It simply rebalances on a regular basis and allocates dollars according to the underlying methodology.
Other Considerations
Index funds are one of the greatest financial innovations for investors, but they aren’t the only strategies that fall on the favorable side of these comparisons.
Factor funds, for example, actively deviate from an index in a low-cost, rules-based manner. But instead of only relying on the size of a company to determine the weighting within a fund (as index funds do) factor funds also consider characteristics such as relative valuation, size, profitability, or momentum when giving weights to holdings within the portfolio.
It’s these types of funds that make the distinction between active versus passive less informative. It also ignores the fact that investors can be highly active using index funds and very passive using active funds.
Nevertheless, I think the evidence is pretty clear that using traditional active managers that attempt to identify and profit from mispriced securities is a strategy with a low probability of success, particularly in stock markets.
Bond investing is a little different though. A significant portion of investors in fixed-income markets have primary objectives that differ from maximizing total returns. Another aspect of bond indexing that is intuitively a bit strange is that the biggest weights within the portfolio go to the most indebted companies.
The way I describe this dynamic is to imagine the two of us walk into a bank for a loan with the same levels of income and net worth, but the only difference is that I have $1 million of outstanding debt and you have only $10,000 of debt. Buying a fixed-income index fund would be like the bank only being willing to lend to me because I have more debt than you. It just doesn’t make sense.
There are some other reasons that I think you could make a strong case for low-cost active management in fixed income including the importance of the new issuance market for bonds compared to stocks, bonds trading over-the-counter rather than on exchanges, and more skewed return distributions for bonds vs stocks.
But I’ll have to dive into those nuances in another episode because that’s all the time we have today.
If you’re enjoying the show, please consider leaving a written review on Apple podcasts or Spotify. You can also learn more about working with a Plancorp wealth manager here.
Until next time, to long-term investing!
Resources
- Episode 70: Thinking of Markets Like Piles of Sand
- Episode 72: The Collective Wisdom of Financial Markets
- Episode 73: Why It’s Hard to Beat the Market with Dr. Andrew Berkin
- Current SPIVA at the time of this recording
- S&P Persistence Scorecard released in April 2022
- Work with a Plancorp wealth manager
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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