Although I don’t spend much time watching financial news, I see more than enough misinformation that too many people seem to treat as fact.
Last week I was appalled — though not surprised — to hear a commentator describe 2018 as likely to be “a stock picker’s year.”
This is the most ridiculous sales pitch for active management I know. And I don’t think “ridiculous” is too strong a word.
The implication is that there’s something special about this particular year that will give active managers an advantage over index funds.
Of course, there was no convincing evidence offered — because none can exist. The one thing I am absolutely certain of is this: Nobody knows what the market will do this year. Nobody.
In theory, it’s possible that most active mutual-fund managers will outperform their benchmarks this year.
But is that likely? Not at all.
The evidence points in only one direction: Active management — or stock picking, if you prefer — is a loser’s game.
The stated goal of active management is to beat the market. While “the market” can be defined in different ways, most investors are willing to accept the S&P 500 as a reasonable benchmark.
Mutual-fund marketing departments would like you to believe the S&P 500 is easy to beat. Academics strongly disagree.
Let’s look at the facts, as compiled in the semiannual SPIVA report produced by S&P Dow Jones Indices, a division of S&P Global.
This report compares the returns of actively managed mutual funds with the returns of public indexes.
The latest report, covering performance through June 30, 2017, includes many asset classes. I’ll focus on four:
- U.S. large-cap funds
- U.S. midcap funds
- U.S. small-cap funds
- U.S. small-cap value funds
I include small-cap value for two reasons. First, it’s an extremely important asset class for long-term investors. Second, it’s often described as a “niche” that skilled stock pickers can supposedly exploit.
The data is unequivocal. Active management loses.
Among large-cap funds, 56.6% failed to match the S&P 500 over one year. Over three years, 81.6% failed. Over five years, 82.4% failed.
Midcap funds did no better. Over one year, 60.7% failed to match the S&P MidCap 400. Over both three and five years, 87.2% failed.
Small-cap funds were similarly unsuccessful. Over one year, 59.6% failed to match the S&P SmallCap 600. Over three years, 88.7% failed. Over five years, 93.8% failed.
What about small-cap value funds — the supposed sweet spot for active managers?
The results were even worse. Over one year, 62.7% failed to match the S&P SmallCap 600 Value Index. Over three years, 92.5% failed. Over five years, 95.2% failed.
In plain English, here’s what this means:
- If you chose a large-cap fund, you had fewer than two chances in ten of beating the market over three or five years.
- If you chose a small-cap fund, your odds were under two in ten over three years and under one in ten over five years.
- If you chose a small-cap value fund, your odds were under one in ten over both three and five years.
- Midcap funds followed the same pattern.
The conclusion is unavoidable. Even with all the brains, technology, and research money available to Wall Street, most active managers fail to even match their benchmarks.
Yet there is still plenty of money to be made by selling hope to investors whose dreams override the evidence.
Track records
“Our managers have beaten the market” is a familiar sales pitch. Sometimes it’s even technically true.
The trick is survivorship bias. If a firm starts with 20 managers and only 10 beat the market, it can quietly eliminate the losers and then claim that all remaining managers outperformed.
The same applies to funds. Poorly performing funds are often closed or merged away. SPIVA reports that only 41.7% of U.S. equity funds that existed 15 years ago are still around today.
The cost of active management
Active management is expensive. All that research, trading, and marketing has to be paid for — by shareholders.
Index funds often charge less than 0.1% annually. Actively managed funds commonly charge ten times that amount.
The shell game
Marketing departments can also distort the truth by changing the definition of “the market.”
A so-called U.S. fund might hold large international positions. When international stocks outperform, the fund looks brilliant — until the cycle reverses.
“Protection” in bear markets?
Another common pitch is that active managers can protect investors in bear markets by moving to cash.
If this were a real advantage, it should have shown up in 2008. It didn’t.
In that severe bear market, fewer than one-third of actively managed funds beat their benchmarks — even worse than their usual performance.
So much for downside protection.
For more on this topic, check out my podcast, The Number One Table of Investment Returns.
Richard Buck contributed to this article.