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Active vs. Passive: 2012 Standard & Poor's Update

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"The year 2012 marked the return of the double digit gains across all the domestic and global equity indices. The gains passive indices made did not, however, translate into active management, as most active managers in all categories except large-cap growth and real estate funds underperformed their respective benchmarks in 2012" – Standard & Poor's Indices versus Active Funds (SPIVA®) Scorecard1

"Very few funds manage to consistently stay on top" – Standard & Poor's (SPIVA®) Persistence Scorecard2

Standard & Poor's recently published its year-end 2012 scorecards comparing the performance of active mutual funds versus their respective benchmarks, as well as the persistence of top performing active mutual funds. Not surprisingly, the results continue to favor the indices.  As shown in Table 1 below, the majority of active managers failed to outperform comparable benchmarks across multiple asset classes beyond 1 year.

Table 1: Percentage of Active Funds Outperformed by Benchmark 

Table 1

1 Year Ending 12/31/2012

5 Years Ending 12/31/2012

US Equity Funds

68.29%

79.04%

Intnl. Equity Funds

47.80%

66.40%

Real Estate Funds

47.10%

77.88%

Fixed Income Funds

42.00%

69.00%

Unfortunately, these results do not fully paint the picture of active management's underperformance. Standard and Poor's return measurements do not take into account the load fees and 12b-1 fees that most active mutual funds charge, which typically range from approximately 0.25% - 5.00% of money invested.3

Beyond performance comparison, two other benefits of the SPIVA performance scorecard are their measurements for Survivorship and Style Consistency for active mutual funds. For example, approximately 1 in 4 of all domestic equity funds did not survive the latest 5-year period. Further, of the original 2,252 domestic equity funds observed, less than 50% remained consistent to their original style over the 5 years. Style drift can include moving across different market capitalizations (e.g. from large cap to small cap), country exposure (e.g. from U.S. only to U.S and Australasia), or price factor exposure (e.g. from value to growth). Table 2 below displays the percentage of funds that survived over the 5-year period ending 12/31/2012 and the number of funds that remained consistent to their original style for the 5-year period ending 12/31/2012 across multiple asset classes.

Table 2: Percentage of Active Funds that Survived & Remained Consistent in Style 

Table 2

5 Years Ending 12/31/2012

% Survived

% Style Consistent

US Equity Funds

73.31%

46.85%

Intnl. Equity Funds

77.01%

75.20%

Real Estate Funds

82.30%

82.30%

Fixed Income Funds

81.85%

78.24%

The lack of asset allocation consistency bears a heavy cost on investors, often exposing their portfolio to unintended risk factors and creating more uncertainty around the assumptions used for financial planning. Obviously, active managers change their styles in an attempt to beat their appropriate benchmark.  Past performance has shown that very rarely do active managers effectively achieve a higher risk-adjusted return over extended periods of time than the overall market, and for those who do, very rarely is it due to "skill."4 Table 3 below confirms the small persistence of top performing active mutual funds. Standard & Poor's compares the top-half rankings for domestic equity funds over five consecutive 12-month periods ending September 2012. By random chance, one would expect to see 6.25% of the original top performing domestic equity funds as top performers in September 2012.

Table 3: Percentage of Active Domestic Equity Funds that Remained in the Top-Half Ranking

Table 3

5 Years Ending 09/30/2012

Remained in Top-Half

Expected by Random Chance

US Large Cap Funds

5.16%

6.25%

US Mid-Cap Funds

3.21%

6.25%

US Small-Cap Funds

5.10%

6.25%

US Multi-Cap Funds

3.91%

6.25% 

We at IFA constantly refer back to market efficiency in describing the consistent underperformance of active funds. Market efficiency refers to the concept that all known information about securities is quickly reflected in the prices observed by any individual at any given time.  This is mainly driven by the competitiveness among market participants and the low cost associated with access to information. Neither IFA nor any financial academic would ever say that markets are "perfectly efficient." That would seem very unrealistic. But what we do believe is that markets are efficient enough that the costs associated with trying to beat them outweigh the intended benefit of doing so. Most of the costs associated with investing include taxes, transactions costs, and market impact costs. For those who invest in active mutual funds, additional costs include management expenses, front-end or back-end load fees, and 12b-1 fees. All of these costs effectively eat up the potential benefit that active managers seek to provide.

As the results from SPIVA's report indicate, the odds of picking an active fund that outperforms its benchmark across all asset classes are less than calling a coin toss. Investors expose themselves to additional market risk from active managers' attempts to outperform a given benchmark. Further, adding the costs associated with investing in active mutual funds makes the probability of outperforming the market extremely unlikely.

Investors' retirement assets should not be left to a guessing game. Buying and holding a portfolio of passively managed, tax efficient, and low cost index funds allow investors to capture the benefits that capitalism provides year after year. Attempting to do otherwise is no better than gambling.   

 

Disclosure

All data used for this article can be found at the S&P Indices Versus Active (SPIVA®) website found here: http://us.spindices.com/resource-center/thought-leadership/spiva/

Specific articles are listed in the endnotes.



1. Standard & Poor's. "S&P Indices Versus Active Funds (SPIVA®) Scorecard." http://us.spindices.com/documents/spiva/spiva-us-year-end-2012.pdf?force_download=true

2. Standard & Poor's. "S&P Indices Versus Active Funds (SPIVA®) Persistence Scorecard." http://us.spindices.com/documents/spiva/persistence-scorecard-december-2012.pdf?force_download=true

3. Investment Company Institute. "Trends in the Expenses and Fees of Mutual Funds, 2011." http://www.ici.org/pdf/per18-02.pdf