"It is very hard, if not impossible," he wrote in his study, "to justify active management for most individual, taxable investors, if their goal is to grow wealth." And he said that those who still insist on an actively managed fund are almost certainly "deluding themselves."
“The Index Funds Wins Again”, Mark Hulbert, New York Times, February 21, 2009
Where Have All the Returns Gone?
As if the recent and severe down markets were not enough to provide perpetual heartburn for fund managers, recent and compelling study results continue to show that the high premium paid to active fund managers drags returns to levels lower than the indexes they attempt to beat.
The eye-opening conclusions emanate from two separate and recent reports:
A Standard & Poor’s study reveals that the majority of actively managed funds fail to outperform simple index funds.
In “Index Funds Are Hard to Beat,” Motley Fool’s Selena Maranjian digs into the results of the S&P study to determine, “funds run by actual human beings still can’t beat a copycat strategy of matching a broad index’s holdings.”
According to the article, the study revealed that for the 5-year time period from January 1, 2004 through December 31, 2008, the S&P 500 Index reported an average annual return of 7.58% while actively managed large-cap funds reported an average annual return of 7.19% on an equal cap-weighted basis.
A five-year comparison is too short a timeframe from which to draw any meaningful conclusions, however, as statisticians tell us that at least 20 years of data are required.
With that in mind, let’s look at a 2007 study which covers a 32-year timeframe. “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” was conducted by Laurent Barras, Olivier Scaillet, and Russ Wermers. The study investigates the presence of true alpha (above-benchmark returns) in the outcomes of 2,076 open-end actively managed domestic equity mutual funds from January 1975 through December 2006.
The study applied the use of t-statistic hypothesis testing and statistical data to compare funds’ relative performance, employing a “False Discovery Test”. This was done to avoid the type of errors that commonly plague statistical analysis and mitigate the effects of false positive and negative results. Unlike many previous studies of mutual fund performance, this method allows for distinctions to be made between fund results based on luck and those based on skill.
Using data which prevents survivorship biases and excludes funds with less than five years of performance history, and taking into account the large effects of active management fees, the study concluded that 99.4% of all fund managers failed to demonstrate true stock-picking ability.
In a July 2008 New York Times article titled “The Prescient Are Few”, journalist Mark Hulbert chronicled the results of the landmark study and its implications. Quoting Prof. Wermers, Hulbert states, "The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives,” says Prof. Wermers--or as Hulbert puts it “just lucky.”
An albeit miniscule percentage of lucky managers may provide a glimmer of hope for a confident investor to entrust their assets to an active fund manager. Our second recent study, however, reveals that even if an active manager is lucky enough to beat the index, any positive return is likely to be swallowed up the higher fees and expenses associated with them, causing the fund to underperform the index when all costs are brought to bear.
A February 2009 study by Mark Kritzman, M.I.T. financial professor showed that after fees and taxes are accounted for, “It is the extremely rare actively managed fund or hedge fund that does better than a simple index fund,” according to Mark Hulbert's February 21, 2009 New York Times article titled "The Index Fund Wins Again".
Kritzman’s study was designed to “accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees,” the article stated.
This task proved to be onerous. “It is surprisingly hard to measure these costs accurately. The bite taken out by taxes, for example, depends on the specific combination of positive years and losing ones, as well as the order in which they occur. That combination and order also affect the performance fees charged by hedge funds,” Kritzman told Hulbert.
“Mr. Kritzman devised an elaborate method to take such contingencies into account,” Hulbert noted. Once these expenses were isolated, Kritzman “calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages,” the article continued.
Kritzman’s elaborate study concluded that when expenses, and taxes (federal and NY state) in the highest tax brackets,even when actively managed funds' gross returns were in excess of the index benchmark by as much as 3.5% to 9%, the net returns, on average, trailed those of the index.
Kritzman determined that expenses related to active funds imposed too great an obstacle for even successful fund managers to overcome, eating up a considerable percentage of returns: “Mr. Kritzman calculated that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year,” cites Hulbert.
A 15-year study conducted by John Bogle revealed the silent but costly impact of fees and expenses. Bogle concluded that the average equity fund investor only kept about 47% of their cumulative returns for the January 1984 through December 1998 time period while an index fund investor held onto a considerably higher 87% of their cumulative returns. The “pie charts” below illustrate the results of the study and the source of the excessive fees and expenses that travel in lock-step with active management.
The implication of the fees analysis that plague active investors leave out a perhaps even more compelling part of the story, which is the fact that winning fund managers cannot be identified in advance. A small percentage, less than 1% according to the Wermer’s study, will beat the index, but it is really only by chance alone that an individual could successfully identify them.
The impact of all of these studies is best summed up in the Kritzman study’s conclusion, “It is very hard, if not impossible to justify active management for most individual, taxable investors, if their goal is to grow wealth,” he stated. “Even in a tax-sheltered account,” Kritzman said, “the odds of beating the index fund are still quite poor.”
Citing Kritzman, Hulbert concluded, “Those who still insist on an actively managed fund are almost certainly 'deluding themselves.’”