“Just wait until next year” was the lament of faithful Chicago Cubs’ fans for over 100 years before last season. From 1908 until their victory over the Cleveland Indians in the 2016 World Series, fans of “the Lovable Losers” would lick their wounds from the previous season while optimistically looking forward to next spring when the Cubs would begin the new season tied for first (along with every other team in Major League Baseball).
“Just wait until next year” has been cry of actively managed U.S. stock fund managers lately too. A report showing the percentage of actively managed funds that underperform their performance benchmarks has been released annually for some time now. Predictably, the response from managers of actively managed funds has been “you need to measure us over a longer-term cycle,” says Aye Soe, managing director of research and design at S&P Dow Jones Indices. These managers insisted that they needed full market cycles (both bull and bear markets) to be fairly scrutinized against their competition.
Until recently, there was not enough data to refute or confirm the claims of these managers. We now have sufficient data to analyze the performance of actively managed funds over a fifteen-year time horizon, thanks to the latest S&P Indices Versus Active (SPIVA) funds scorecard.
With the latest SPIVA scorecard there now exists fifteen years of data comparing the performance of U.S. actively managed funds to their respective benchmarks. This longer time horizon provides a complete market cycle to measure the efficacy of managers across all asset classes. Unfortunately, for the managers of actively managed funds, the new data set does not support their claims.
The data in the Year-end 2016 SPIVA U.S. Scorecard shows that 92.15% of all actively managed US Large-Cap funds were outperformed by the benchmark (or index) over a fifteen-year period. Stated another way, only 7.85% of all actively managed US Large-Cap funds beat their benchmark over a fifteen-year period of time. Over that same fifteen-year timeframe, actively managed US Mid-Cap funds were beaten by their benchmark 95.40% of the time. Actively managed US Small-Cap funds were bested by the benchmark 93.21% of the time.
Active managers of domestic funds should not feel so bad, their counterparts in International and Emerging Market funds have performed poorly as well. Data made available from S&P Dow Jones Indices shows that 84.1% of International funds and 89.7% of Emerging Markets funds underperformed their benchmark over the ten-year period ended December 31, 2015.
It appears that more investors are getting the message. Since March of 2007, $1.2 trillion has been withdrawn from US actively managed stock funds. Of that $1.2 trillion, $1.1 trillion has been placed in investments (including passive investment firms like Vanguard and Dimensional Fund Advisors) that closely mirror the benchmarks funds are measured against.
Another measure of tracked in the SPIVA U.S. Scorecard report provides further evidence of the futility in trying to outperform market benchmarks with actively managed funds. The SPIVA U.S. Scorecard also tracks survivorship for mutual funds. Survivorship tracks the percentage of mutual funds that remain (or survive) from the beginning of the time period in question to the end. Over the fifteen-year time period of the study, it was found that only 34.11% of U.S. Large-Cap, only 49.14% of U.S. Mid-Cap, and only 51.99% of U.S. Small-Cap funds were survivors. Funds can close, or cease to exist, for a variety of reasons, but underperformance is often one of the main reasons that actively managed funds close down because it makes the fund family look bad when there are funds that perform poorly.
Looking at the survivorship numbers and the percentage of mutual funds that underperform, it is unlikely that an investor will choose any U.S. actively managed funds that will survive for fifteen years. It is even less likely that an investor will choose an actively managed fund that will outperform its benchmark. You may ask yourself then, why would anyone invest in actively managed funds? It is very unlikely that they will outperform their benchmark; it is also unlikely they will be around in fifteen years, and they generally cost two to five times as much as their cheaper passively managed counterparts.
The real answer is probably a little more complicated, but I can think of three very good reasons that investors continue to invest with actively managed funds: greed, tradition, and their broker told them this was the best way to invest. For some investors greed, aka “beating the market” holds such a strong attraction that this emotion overrules logic even when presented with the evidence that overwhelmingly shows the folly of investing in actively managed funds or following market-timing or stock-picking strategies. Tradition holds its own power over some investors: this is the way investing has always been done and the only measure of success is beating the market benchmark. We cannot overlook the role brokers have had in perpetuating the existence of actively managed funds. Actively managed funds have traditionally been sold to investors by brokers earning commissions. When a broker suggests to an investor that it may be time to replace a fund for poor performance, he or she earns another commission and looks to be proactive in the eyes of the investor client.
I have been asked by a few astute clients over the years “what would happen if everyone stopped investing in actively managed funds, or eschewed stock-picking and market-timing strategies for passively managed investments?” The implication of the question is that stock market behavior would change if everyone invested passively, or bought and held all of their investments.
I tell these clients “not to worry; there will never be a time when all investors invest in passively managed or index funds.” How do I know this for certain? A few years back while attending a Dimensional Fund Advisors (DFA) conference, Dr. Ken French of Dartmouth University spoke. Dr. French and his research partner, Nobel Laureate Dr. Eugene Fama, are both board members and serve on the Investment Policy committee for DFA. One of the advisors who utilizes DFA funds for his clients asked Dr. French the same question asked in the previous paragraph. Dr. French smiled whimsically and said something to the effect that if every other investor in the world invested in passively managed or index funds, even the staunchest of supporters of passive management: he would begin investing in active management strategies to exploit the tiny inefficiencies that naturally occur in the stock market.
Investors should remember the cry of Chicago Cubs fans “wait until next year” when they hear the alluring tale of the stock fund that “beat its Lipper average for the past five years” or the siren song of the “can’t miss investment strategy.” While “next year” may come for the Chicago Cubs again, like it did in 2016, “next year” never comes for actively managed funds or the managers in charge of those funds. Now we have the evidence that proves it!