The securities industry is working itself into a frenzy trying to explain why you should ignore historical data that indicates most actively managed funds underperform their benchmarks. Some of the reasons they provide do not withstand scrutiny. Here’s a small sample of their lame excuses:
1. Last year was an aberration. According to Dan Culloton, Morningstar’s associate director of manager research, as interviewed by Kathleen Pender in a December 2014 SFGate article, most domestic funds own more small and mid-cap equities than the Standard & Poor’s 500 index. Large-cap stocks outperformed small-cap stocks in 2014. Because the S&P 500 index contains mainly large-cap U.S. stocks, actively managed funds couldn’t “keep up.”
Really? According to the mid-year 2014 SPIVA U.S. Scorecard, most domestic stock funds underperformed their benchmarks over the past five years. There was nothing aberrational about 2014.
2. International stocks hurt active fund managers. In the same article, Rajat Jain, a principal with Litman Gregory Asset Management, says actively managed funds had a rough time beating the S&P 500 index in 2014 because of their exposure to foreign stocks, which “massively trailed the U.S.” last year.
It’s true that international stocks had a down year. And if you weren’t familiar with the data, you might be inclined to believe Jain’s explanation. In the past five years, most global funds, international small-cap funds and emerging market funds underperformed their benchmarks. The only exception was international small-cap funds, but even in that asset class, 45.7 percent underperformed their benchmark.
In some of those years, international stocks did very well. And in 2009, emerging markets were the best-performing asset class, significantly outperforming large-cap stocks. Whether international stocks are up or down, the majority of active stock funds have underperformed their benchmark.
3. The wrong benchmark is being used. Some fund managers complain they’re being measured against the wrong benchmark. For example, the performance of a fund specializing in small-cap stocks should not be compared to the returns of the S&P 500 index. Reputable financial analysis outfits know the difference between correct and incorrect benchmarks. The SPIVA U.S. Scorecard, which is the source of data to which I refer, notes: “Fund returns are often compared to popular benchmarks such as the S&P 500, regardless of size or style classification. SPIVA Scorecards avoid this pitfall by measuring a fund’s returns against the returns of a benchmark appropriate for that particular investment category.”
Here’s the harsh truth. When the majority of actively managed funds are compared against undeniably correct benchmarks, they underperform — especially over the long term.
4. Index funds give you “average” returns. The mutual fund industry is fond of repeating this mantra: “Index funds only give you ‘average’ returns.” Since most investors don’t consider themselves “average,” the lure of actively managed funds lies in the possibility of above-average returns. There are two problems with this reasoning. The premise is incorrect, and chasing returns will most likely result in underperforming the index.
As my colleague Larry Swedroe, director of research for the BAM ALLIANCE and Andrew Berkin, Ph.D., discussed in their new book, “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches,” index funds and funds designated as “passively managed” produce above-average returns for investors.
The authors looked at Morningstar percentile rankings as of Oct. 31, 2014, for domestic and international funds. For seven Vanguard index funds, the average 10-year and 15-year rankings were in the top 30 percent and 51 percent of funds, respectively. If survivorship bias were accounted for (adjusting for funds that didn’t survive, typically due to poor performance) the authors surmise these rankings would be significantly better.
When they looked at passively managed funds from Dimensional Fund Advisors, they found that for the 13 funds analyzed, average 10-year and 15-year rankings were in the 22nd percentile and 23rd percentile, also without accounting for survivorship bias.
Here’s the bottom line: When survivorship bias is taken into account, index funds and passively managed funds outperform the majority of actively managed funds. Since mutual funds report returns pretax, and index funds and passively managed funds are more tax-efficient, the numbers after-tax would be even worse for active management.
Don’t believe the lie that index funds give you “average returns.”
When you look closely at the lame excuses offered by proponents of active management, you can fully appreciate this conclusion from Swedroe and Berkin: “Active management is the triumph of hype, hope and marketing over wisdom and experience.”
Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is “The Smartest Sales Book You’ll Ever Read.”
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Wall Street’s Lame Excuses for Active Fund Performance originally appeared on usnews.com
