One More Nail in the Coffin of Active Management

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“The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”

-S&P Dow Jones Indices versus Active Funds (SPIVA ®) Scorecard of 12/31/2011

S&P Dow Jones Indices recently published its eagerly awaited year-end 2014 scorecard, and for the first time, they tabulated the results of the ten-year period. The story for actively managed funds continues to remain dismal, as seen in the table below.

Percentage of Active Funds Outperformed by Benchmark
10 Years (1/1/2005 to 12/31/2014)
Calendar Year 2014 10 Years Ending 12/31/2014
Domestic Equity Funds 78.1% 84.1%
Real Estate Funds 80.1% 78.1%
Non-U.S. Equity Funds 71.2% 81.5%
Fixed Income Funds 56.7% 73.4%

The quote above could actually have been updated by replacing “five-year” with “ten-year” and replacing “most” with “all but two”—Investment-Grade Intermediate Bond Funds at 49.1% and Global Income Bond Funds at 46.8%, neither of which did substantially different from a coin toss.

Since its ultimate source of data is the Mutual Fund Database from the Center for Research in Security Prices, SPIVA accurately accounts for funds that failed to survive the period due to merger or liquidation. The well-known commercially-used fund databases suffer from this survivorship bias which causes active managers as a group to appear to have better returns than is actually the case. Another helpful aspect of SPIVA is its tracking of style consistency among active funds. For the ten years ending 12/31/2014, only 33.7% of all active domestic equity funds both survived the period and maintained the same style. For investors who are concerned with maintaining a consistent asset allocation, actively managed funds are poor vehicles.

Once again, as we dig into the data, we see some of the myths that are busted by SPIVA.

Myth:  Indexing is fine for large-caps, but since the small-cap market is inefficient, an active manager can take advantage of those inefficiencies and thus outperform a small cap index.

Fact:  Over the last decade, SPIVA data indicates that indexing worked even better for U.S. mid/small-caps as it did for U.S. large-caps. The table below provides the numbers.

Percentage of Active Funds Outperformed by Benchmark
10 Years (1/1/1995 to 12/31/2014)
  10 Years Ending 12/31/2014
Large-Cap Domestic Equity Funds 78.8%
Mid-Cap Domestic Equity Funds 89.4%
Small-Cap Domestic Equity Funds 89.3%
Multi-Cap  Domestic Equity Funds 83.2%

Indexing is fine for U.S. equities, but for foreign equities, active management can add more value.

Fact: SPIVA tracks four different categories of international and emerging markets equities, and the table below shows how the majority in all of them has lagged the benchmark.        

Percentage of Foreign Active Funds Outperformed by Benchmark
10 Years (1/1/1995 to 12/31/2014)
  10 Years Ending 12/31/2014
Global Funds 79.2%
International Funds 84.1%
International Small Cap Funds 58.1%
Emerging Markets Funds 89.7%

Even though the majority of active funds have not kept up with their benchmarks, investors as a group have benefitted from them due to the few funds that have delivered outperformance.

Fact: In addition to tracking the percentage of funds that underperform, SPIVA also tracks the asset-weighted average return delivered by each category, and the table below shows how almost every category lagged its benchmark.

Asset-Weighted Annualized Fund Return minus Benchmark for U.S. Equity Funds
10 Years (1/1/1995 to 12/31/2014)
  10 Years Ending 12/31/2014
Large Cap Growth Funds -1.45%
Large Cap Blend Funds -1.08%
Large Cap Value Funds  0.12%
Mid Cap Growth Funds -1.05%
Mid Cap Blend Funds -1.06%
Mid Cap Value Funds -1.11%
Small Cap Growth Funds -1.10%
Small Cap Blend Funds -1.26%
Small Cap Value Funds -1.01%
Multi Cap Growth Funds -0.41%
Multi Cap Blend Funds -0.96%
Multi Cap Value Funds -1.03%
Real Estate Funds -1.07%

As for the one category that got a higher return than the benchmark (large cap value), that is explained by the fact that that category had the lowest return, meaning that large value managers who drifted into other categories benefitted.

Of course, a naïve reader of SPIVA could argue that it does not apply to him because he will find the rare manager who can consistently outperform his peer group. SPIVA’s companion report, The S&P Persistence Scorecard belies this claim. It shows that year after year, the number of managers who remain in the top quartile of their peer group is less than 25% (what we would expect from chance).

Even if an investor thinks he has found a manager who has outperformed his benchmark over a long period, a statistical test such as the t-test will often show that luck cannot be ruled out as the explanation. In fact, for the two funds in the chart above that remained in the top quartile for all five years, we ran a t-test and found that their outperformance was not statistically significant (see this article for further details). Interestingly, Jeff Sommer of the New York Times just did a follow-up article on those two funds and found that one of them is now in the bottom quartile while the other is in the second-to-bottom quartile. As Keith Loggie, the senior director of global research and design and S&P Dow Jones Indices, was quoted in that article:

“Looking at the numbers, you can’t tell whether there is skill involved in what they do or whether their performance is just a matter of luck. I believe that many of them do have skill. But even if they do have it, based on how they’ve done in the past you really can’t predict how they will perform in the future…It’s possible that any one of these funds will beat the market over the long term. Some of them will do that. But the problem is that we don’t know which of them will do that in advance.”

This is why we at Index Fund Advisors often refer to manager picking as a mug’s game. To summarize, would-be manager-pickers would do well to read the SPIVA report along with the S&P Persistence Scorecard and take their lessons to heart.