David Peartree, The Daily Record Newswire
One upside of a debate that simmers over many years is that it allows time for data to accumulate, bolstering one side and undercutting the other. Such is the case with the debate concerning active management versus index-based investing.
In the early years, starting in 1976 when John Bogle at Vanguard launched the first index mutual fund, there wasn’t much of a debate because there wasn’t much data. In fact, some initially referred to Vanguard’s S&P 500 index fund as “Bogle’s folly.” A fund that strives to be average, how laughable.
Now, almost 40 years later, the active management community is not conceding defeat, but neither is it laughing any more. Bogle’s supposed folly has become a widely emulated investment approach and index investing is at the very least grudgingly respected.
Over the years, a number of academic studies have reported on the difficulty actively managed funds have matching or exceeding their relevant market benchmark. Since 2003 the S&P Dow Jones Indices has published semi-annual and annual reports known as SPIVA report, the S&P Indices Versus Active.
SPIVA has become the de facto scorekeeper measuring the performance of actively managed funds against their relevant S&P index benchmarks. For 2013, SPIVA reported, “the majority of the active managers across all the domestic equities categories failed to deliver returns higher than their respective benchmarks.”
Over 55 percent of U.S. large-cap managers and 68 percent of U.S. small-cap managers underperformed their respective benchmarks. U.S. mid-cap managers were the exception: only 39 percent failed to perform their benchmark over the calendar year, meaning about 60 percent did.
Those findings are no surprise. Over any 12-month period, the results of active management versus the indices are mixed. The numbers of active managers able to beat their benchmark in any given year may be less than a majority, in most cases, but there are always enough to encourage investors to hope.
The longer-term data is more sobering, however, and does not favor active management. Over three- and five-year periods, the percentage of active funds outperforming their benchmark declines significantly. In the most recent report, the majority of active managers in all U.S. equity categories failed to outperform their benchmarks.
The results for U.S. small-cap equities are particularly interesting because a common argument is that active managers have a better opportunity to outperform in markets that are less efficient, such as small-cap or emerging markets. The data does not support the claim. In only two of the past 10 years did small-cap managers outperform their benchmark. Over the 10-year period from 2004-2013, a full two-thirds (65.3 percent) underperformed.
Another way to compare performance is a straightforward comparison of returns. SPIVA looks at both “asset-weighted returns” and “equal-weighted returns.” An asset-weighted return calculates fund returns based on how much investors have in each fund. A larger fund is given more weight than a smaller fund. An equal-weighted return simply takes the average all fund returns irrespective of size.
An asset-weighted return is a better indication of the overall experience of investors, but an equal-weighted return is still an accurate measure of average manager performance.
If the U.S. equity market is further broken apart into nine style categories, a common breakdown by Morningstar, active managers failed to match or beat the benchmark in seven of the nine categories. Over the five-year period ending 2013, the asset-weighted results of active managers beat the benchmark in only two sub-categories: large-cap growth (19.35 vs. 19.24 for the benchmark) and small-cap growth (22.99 vs. 22.79 for the benchmark).
Finally, the SPIVA report also shows the inferior performance of active funds during bear markets, another situation where it is often claimed they can outperform. In 2008, large-cap value was the only category in which a majority of active managers were able to outperform the benchmark index.
The SPIVA report leads to the following conclusions.
First, while one-year results may vary, the longer the time frame, the greater the likelihood active managers will underperform.
Second, indexing works even in “inefficient” markets like small-cap stocks.
Third, active managers struggle to keep pace in bull market and bear markets. Index investing tends to outperform regardless of market cycles.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
