The Wall Street Journal recently published a series of articles under the title “The Passivists.” Highlighting the merits of a passive investment approach, authors tackle topics such as the fruitless endeavor of trying to pick winning stocks to the “Do Nothing All Day” investment approach taken by Nevada’s $35 Billion pension fund. For each article we provide a synopsis as well as our own additional comments to build upon the great work highlighted in this series.
Chairman of well-known Capital Groups, Timothy Armour, explains why investors don’t need to settle for index funds with the use of simple analogies and examples of past performance using American Funds, a subsidiary of Capital Groups. At face value, many investors may believe that Mr. Armour is providing sound investment advice based on his successful career in the industry. He must know what he is talking about, right?
The irony of this advice that he is purporting to the masses is that it is literally impossible for the majority to do successfully. As we will show, not only does it defy basic arithmetic, but is not supported by both academic evidence and American Funds’ own historical performance. Once we remove the cloak of best intention investment advice, we believe the true intentions present themselves.
Mr. Armour begins with a simple analogy of comparing Blockbuster to Netflix back in the early 2000s, “you don’t need 20/20 hindsight to have made the right call – plenty of investors thought video-rental stores were a dying business. But an index fund makes no judgments or distinctions.” He continues by stating, “the best managers spend time researching companies –applying in-depth analysis to inform their views and to uncover insights on the companies’ future prospects.”
The reality though is that index funds do in fact make judgments. It is not taking one side over another; rather, an index represents the collective or aggregate judgments of all market participants. The main difference is that index fund investors replace overconfidence with humility in understanding the limitations of their own ability. It is safe to say that all active managers are following the same process of researching companies and applying an in-depth analysis. To come out ahead of thousands, if not, millions of other market participants one or a few of the following must be true:
- You have more tools at your disposal for analyzing information (i.e. can make a better assessment)
- You have access to information that other market participants do not
- You receive publicly available information faster than other market participants
- You have superior analytical capabilities compared to other market participants
- You can more cost effectively implement your assessment of a company into an actual investment strategy
Given the extremely competitive nature of the capital markets and money management, in general, the items on list seem very suspect. What is a more plausible explanation is that Lady Luck is anointing some as winners while punishing others as losers. Wash, rinse, and repeat as investors continually chase past returns.
While simplification is great for understanding, oversimplification can hide important details.
The Arithmetic of Active Management
Nobel Laureate, Bill Sharpe, published a famous paper entitled “The Arithmetic of Active Management” in 1991. His premise was very basic, but powerful at the same time: “before costs, the return on the average actively managed dollar will equal the return of every passively managed dollar and after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” The market is a zero-sum entity. For every winner, there must be a loser. Passive investors just go along for the ride, believing that their chances of knowing more than the collective wisdom of the entire market are dismal to none. The average actively managed dollar is the average passively managed dollar, before expenses since they both represent the entire market, as it exists. Once we take into account the higher fees, trading costs, and taxes associated with active investing, passive always wins.
This is an important concept to understand since it proves that not all active investors can be winners. In fact, not even a majority of them can be winners. So to tell investors as a whole that they do not need to settle for the average is very misleading. A more accurate statement would be, some of you don’t have to accept the average and most of you would probably be better off accepting the average through a passively managed index fund.
A common response to this argument is that it is based on “average” performance, lumping together both the exceptional and the not so exceptional. This is true and an important follow up question would be to examine if there are any active managers that have persistently outperformed the rest over time. Similar to flipping 15 “heads” in a row, research suggests that the number of active managers who have outperformed the market over time is the same as we would expect by random chance alone. This was documented in Eugene Fama and Kenneth French’s 2010 paper, “Luck versus Skill in the Cross-Section of Mutual Fund Returns” and recently updated by Dimensional Fund Advisors, which you can find a synopsis of here. So it’s hard to decipher whether actual skill was displayed or if chance played an important role.
Is does still beg the question of whether or not Capital Group finds itself in the category of exceptional. Let’s take a look.
Walking the Walk
Earlier this year we took a look under the hood of American Funds, a subsidiary of Capital Group, to see if they were delivering on their value proposition to investors of consistent outperformance relative to their appropriate benchmarks. Here is what we found based on 57 of their actively managed mutual funds:
- 42% (24 funds) have underperformed their respective benchmarks since inception, having delivered a NEGATIVE alpha
- 58% (33 funds) have outperformed their respective benchmarks since inception, having delivered a POSTIVE alpha
- 12% (7 funds) have outperformed their respective benchmarks consistently enough since inception to provide 95% confidence that such outperformance will persist as opposed to being based on random outcomes
We can say, in general, that American Funds has done a little better than what is expected by random chance in terms of outperforming their benchmark. Of the 7 funds that outperformed with a high degree of confidence, 4 of them only have 5 years or less of performance history. It is dangerous to make statistical conclusions based on a very small sample size. Just one more year of performance history can dramatically change conclusions made about performance.
That leaves us with just 3 that have outperformed their respective benchmarks. It is important to note, as we mentioned in Eugene Fama and Kenneth French’s research, that we would expect 2 to have statistically significant alphas just by random chance alone.
Have American Funds really proved that they are a superior asset manager? Based on our analysis, their performance has been about what is expected by simple chance.
While it is easy to look in the past and say, “Netflix was such as slam dunk” and that investors don’t have to settle for average, it is important to understand that this is oversimplifying how difficult it is to beat the market over time. First, it is not possible for the majority of active investors to be winners since it defies basic arithmetic. Second, the number of active manager who did beat the market over time in the past is the same as we would expect by random chance making it hard to decipher whether or not actual skill was displayed. Lastly, based on American Funds’ own track record, it seems overly confident by Capital Group’s CEO to say that settling for average is not necessary. Their performance has also been similar to what is expected by random chance.
Without an overly significant statistical argument for active management, a much more prudent approach would be to buy and hold a globally diversified portfolio of index funds that matches an investor’s capacity to take risk.
You can find the original article published in the Wall Street Journal here.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.