Style Drifter

Large Cap Active Managers on Track for Record Low Performance

Style Drifter

As we were enjoying our Thanksgiving Day weekend, this Jason Zweig column in the Wall Street Journal caught our attention. Zweig quotes Denys Glushkov, a senior researcher at Wharton Research Data Services at the University of Pennsylvania, as saying that only 9.3% of active large cap domestic stock managers have beaten the S&P 500 Index for the first nine months of 2014. Thus, 2014 is on track to do worse than the previous annual low of 12.9% in 1995. The average percentage over the last 25 calendar years is 38.6%. According to Mr. Glushkov, "2014 is likely to enter the record books as the year when active equity fund delivered their worst performance relative to the index, net of fees, since at least 1989."

What explains this extreme level of underperformance? The answer, in two words, is "style drift". With the exception of real estate investment trusts, U.S. large cap stocks have been the star performer in global markets.  This means that any large cap manager who deviated away from large cap stocks would have likely underperformed the index. For example, Zweig cites Morningstar data that the average U.S. stock fund has 5% of its assets in foreign stocks, and since foreign markets have trailed the U.S. market by 14 percentage points so far this year, the style drifting managers have suffered.

An additional type of style drift that has exacerbated their underperformance is related to size. As of 9/30/2014, the IFA U.S. Small Cap Index has lagged the IFA U.S. Large Company Index by about 12.2 percentage points year-to-date. Therefore, any large cap managers who drifted into small cap stocks paid a price for it. In our part of the investment world, the tendency for active managers in the best-performing asset classes to underperform their benchmarks is referred to as Dunn's Law, a term coined by investment theorist William Bernstein in honor of his friend, Steven Dunn.

A final explanatory factor cited by Zweig is the low level of dispersion (the range of returns) in the cross-section of individual stock returns in 2014. Many financial writers have attributed manager underperformance to the high level of correlation among individual stock returns, but as this Vanguard Research article explains, stock can be highly correlated yet still have a wide dispersion, allowing for the possibility of active managers to shine or drastically fail.

As with many of his articles, Zweig obtained a statement from the Father of Retail Indexing, John Bogle, who cautioned, "I'm concerned that people will say that indexing will always win or always win or always win this big. This level of outperformance just doesn't happen for long." At Index Fund Advisors, it is our position that in every asset class in which investors index, they can expect to beat the majority of actively managed dollars, and over longer periods of time, the probability of outperformance approaches unity. Recently, we put up this calculator to help investors see just how much the odds are against them when they utilize a combination of actively managed funds in their portfolio.

If you are invested in active funds and would like to learn about a better way to invest, please give us a call at 888-643-3133.