Wednesday, April 8, 2015

Index Funds vs Actively Managed Funds

Some recent research by S&P Dow Jones Indices found that, among other things, the vast majority of U.S. actively managed equity funds did not beat the relevant benchmark over ten years.

Here's a quick summary of U.S. equity fund performance over a ten year period.*

- All Domestic Equity Funds: 76.54% underperformed

- All Large-Cap Funds: 82.07% underperformed

- All Mid-Cap Funds: 89.71% underperformed

- All Small-Cap Funds: 87.75% underperformed

From the report:

"It is commonly believed that active management works best in inefficient environments, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA Scorecard. The majority of small-cap active managers have been consistently underperforming the benchmark over the full 10-year period..."

The results, with one exception, were similar for the 14 other U.S. equity fund categories included in the report.**

According to the report, "the majority of the active managers" that invest in international stocks also performed worse than their benchmarks over the same time frame.***

This should hardly be a surprising result. John "Jack" Bogle has been trying to educate others on the wisdom of low cost index funds over actively managed funds for decades.

Here's how Mr. Bogle once explained it:

"The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!

But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."

The S&P Dow Jones Indices research does "account for the entire opportunity set—not just the survivors—thereby eliminating survivorship bias." Any comparison that doesn't account for the funds that are liquidated or combined with other funds during a particular period isn't going to paint a realistic picture.

The research shows result for shorter time frames but, at least to me, ten years is barely a long enough time horizon to make meaningful judgments. It's performance over decades that matters all risks considered.

It may not be impossible to figure out which fund will outperform going forward over the longer haul, but at least investors should carefully consider just how difficult it might be.

Of course, it's possible that active managers are will do much better going forward but, if nothing else, some skepticism seems warranted.

Think of it this way:

Where else does a simple cheap product exist that offers the non-expert a chance to keep up with the experts -- or, if this research is any indication, possibly outperform the vast majority of the experts -- over the longer haul?

The tough part for many is avoiding the temptation to be more active than they probably should be and end up making inopportune portfolio moves.

Some investors tend to underestimate how excessive confidence and other factors can adversely impact results.

Some relevant Bogle advice:

1) " investing, realize that you get what you don't pay for. Whatever future returns the markets are generous enough to deliver, few investors will succeed in capturing 100% of those returns, simply because of the high costs of investing—all those commissions, management fees, investment expenses, yes, even taxes—so pare them to the bone."

2) "Don't do something, just stand there. Own American business...a broadly diversified portfolio of lots of companies and industries. Buy such a portfolio, never sell, and hold it forever."

3) "Invest for the long term—decades, even a lifetime—and start as soon as you can. No one knows what stocks will do tomorrow, or even what they'll do over the next few decades, but over the long pull, the dividends and earnings growth of American business will be reflected in rising stock prices."

He also says to avoid "stupid mistakes" including things like -- though not limited to -- making impulse investments, buying based upon tips, and letting emotions rule over reason.

Jack Bogle's market advice: 'Don't do something, just stand there!'

Ultimately, the "humble arithmetic" is unavoidable.


Related posts:
John Bogle on Investor Returns
Buffett's Hedge Fund Bet
John Bogle's "Relentless Rules of Humble Arithmetic", Part II
Index Fund Investing Revisited
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* See page 4. Source: S&P Dow Jones Indices LLC, CRSP. Data as of Dec. 31, 2014. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.
** Large-Cap Value Funds: 58.76% of the funds underperformed their benchmark index over ten years. This may be a relatively better performance versus the other categories, but most funds in this group still could not outperform their benchmark.
*** Results on page 10.
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