By George Sisti
Proponents of active management claim that gifted managers can identify stocks that will rise in price and shun those that will decline.
They can sell stocks in advance of any serious market decline and re-enter the market before the rebound, thereby outperforming their benchmark index. Let’s look at a recent report that debunks these claims.
Standard & Poor’s recently released its year-end 2013 S&P Indices Versus Active Funds (SPIVA) Scorecard that compares the performance of actively managed mutual funds to their S&P benchmark indexes. For the five years ending on Dec. 31, 73% of large-cap domestic funds, 78% of midcap funds, 67% of small-cap funds and 80% of REIT funds underperformed their benchmark indexes. Almost two out of three actively managed domestic stock mutual funds underperformed the S&P 1500 total stock market index over the past five years.
Propagandists for active management have a ready excuse for these disappointing results. They admit that it is difficult for fund managers to outperform index funds during rising markets. A rising tide floats all boats and the upward trajectory of a bull market creates an ideal environment for passive investors. But all bull markets eventually end and advocates of active management assert that this is when investors in actively managed funds will be rewarded.
So let’s journey back in time to investigate this claim. The Standard & Poor’s 500 Index /quotes/zigman/3870025/realtime SPX -0.29% declined 57% from October of 2007 through March of 2009. Passive index investors remained invested during these turbulent and demoralizing months, while active managers had the opportunity to move to cash and protect shareholders from the decline.
Yet according to the year-end 2009 SPIVA Scorecard , 49% of large-cap funds, 74% of midcap funds, 63% of small-cap funds and 52% of REIT funds underperformed their benchmark indexes for the three-year period 2007 through 2009. At the time, 54% of all actively managed domestic stock funds underperformed the S&P 1500 Total Stock Market Index . Active managers, as a group, failed to fulfill their promise to protect investors during the financial crisis. The theoretical opportunity to outperform stock market indexes doesn’t often translate into reality.
Most investors are unaware of the high fatality rate of poor performing actively-managed funds. Of the 3,033 domestic stock funds available to investors onNew Year’s Day 2009, 785 (26%) were merged or liquidated by by the end of 2013.
A recent academic paper, Scale and Skill in Active Management studied the performance of 3,126 actively managed domestic stock funds from 1979 through 2011. The authors noted an interesting dichotomy in their conclusion: "We find that the active management industry has become more skilled over time. Despite this rise in skill, average fund performance has failed to improve."
The authors also noted that, "the extent to which an active fund can outperform its passive benchmark depends not only on the fund’s raw skill in identifying investment opportunities but also on various constraints faced by the fund."
The authors identified two primary constraints working against active managers:
Fund size — The authors discovered that new, smaller funds tend to outperform older, larger funds. They identified some possible reasons for this outperformance. New fund managers may be more skilled than incumbent fund managers and perhaps have higher levels of education or a greater command of new technology.
Also, performance deteriorates over a typical fund’s lifetime. Successful funds grow quickly as new investor money pours in. The manager is forced to buy more securities and as the number of stocks in a fund’s portfolio increases, the more difficult it becomes to outperform its benchmark index. A large fund’s trading activity can also have a negative impact on the price of the stocks it is buying or selling, eroding the fund’s performance.
Industry Size — The active management industry has become more skilled over time, with more highly skilled competitors entering the marketplace. The authors concluded that, "As more money chases opportunities to outperform, prices move, making such opportunities more elusive." This is especially true for funds that trade aggressively.
Consequently, " the growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack."
The authors’ conclusions confirm my Whack-A-Mole theory of manager underperformance. If it’s just you with the mallet, you’ll get the mole every time. But you’ll hit fewer moles if there are 10 mallet wielding competitors surrounding the game console. It’s really that simple — more whackers means that every player hits fewer moles.
These two reports add to the growing body of evidence that shows the improbability of outperforming a passive investment strategy over the long-term. But as long as fortunes can be made by obscuring the facts, voices proclaiming the fictional benefits of active management will never fall silent.