Intelligent Design

John McMillen | Portfolio Manager

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How Many Active Managers Really Add Value?

August 2008

Given that 87% of new investment dollars invested in mutual funds last year went to actively managed funds (those that attempt to beat the market), it is clear that the vast majority of investors stubbornly cling to the belief that they can find market-beating funds.

Looking at the hard facts, however, one has to ask: Why?

Those facts are best seen in a report Standard & Poor’s publishes entitled the “Standard & Poor’s Index Versus Active” (SPIVA) table, a scorecard that provides an accurate accounting of active managers’ performance vs. their respective style categories.

The most recent SPIVA table listed below shows the percentage of actively managed equity funds that have underperformed their respective benchmarks (indexes).

 

Fund Category
Comparison Index
Last Quarter
One Year
Three Year
Five Year
All Domestic Funds
S&P Composite 1500
33.72
73.77
59.01
61.39
All Large Cap Funds
S&P 500
35.87
70.75
65.72
72.22
All Mid Cap Funds
S&P MidCap 400
84.82
61.46
68.63
77.38
All Small Cap Funds
S&P SmallCap 600
53.51
56.52
80.20
77.67
Large Cap Growth Funds
S&P 500/Citigroup Growth
18.04
77.24
50.11
59.77
Large Cap Blend Funds
S&P 500
31.15
74.62
67.96
74.69
Large Cap Value Funds
S&P 500/Citigroup Value
63.90
80.91
90.00
89.28
Mid Cap Growth Funds
S&P MidCap 400/Citigroup Growth
86.56
69.57
70.41
84.35
Mid Cap Blend Funds
S&P MidCap 400
86.11
56.00
64.71
74.24
Mid Cap Value Funds
S&P MidCap 400/Citigroup Value
83.78
32.14
60.00
69.57
Small Cap Growth Funds
S&P SmallCap 600/Citigroup Growth
72.76
65.84
86.27
87.84
Small Cap Blend Funds
S&P SmallCap 600
61.70
65.28
87.64
80.39
Small Cap Value Funds
S&P SmallCap 600/Citigroup Value
31.63
45.50
74.32
59.28

Source: SPIVA. For period ending March 31, 2007. Outperformance is based upon equal-weighted fund counts.
 

As the table shows, over short time periods, many actively managed funds will outperform their benchmark. But as time periods get longer, the realities of active management – high fees and trading costs – quickly catch up with active funds. Over the longest measured time period (five years), between 59.28% and 89.28% of actively managed funds failed to beat their benchmark.

It is particularly interesting to note the percentage of small-cap funds that underperformed the benchmark over the five-year period (the fourth line in the table) – almost 8 out of 10! This would seem to refute the popular notion that small-cap managers are able to add more value relative to their large cap peers.

In a highly efficient market, active managers struggle with their value proposition – identifying mispriced securities and taking advantage of them. Even if such mispricings do occur, they do so in such a random fashion that is extraordinarily difficult for an active manager to exploit them on a consistent enough basis that it becomes a viable strategy.  

These numbers should give all investors pause, because clearly, as a group, active managers have been abysmal failures at adding value, and that has cost investors in those funds untold billions.

And yet the chronic underperformance of most active managers only tells half the story. Given that money-weighted rates of return (what investors actually earn) are usually lower than time-weighted rates of return (what the fund actually returns) due to common investor behaviors, (e.g., market timing, chasing returns) the complete story is that many investors are likely underperforming their already underperforming fund!   

This highlights a common fallacy that investors have about index funds – that using such funds dooms one to accepting “average” returns. Clearly there is a big difference between getting the return of the market average and getting average returns! Looking at the historical data, index-fund investors who lock in the benchmark return by staying invested are virtually assured of out-performing 80% or more of active-fund investors over long time periods (10 years or more).

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