Jay D. Franklin
Indexing: Is It Appropriate for All Asset Classes?
Jay D. Franklin
Monday, September 19, 2011
A recent article on morningstar.com addressed the question of whether active management can add value in areas of the market beyond domestic large cap equities. The views of various members of Morningstar’s discussion boards provide a variety of reasons as to why so many retail investors believe that indexing is only good for US large cap stocks. For example, regarding bond funds, one poster opines, “Certain managers understand how to adjust quality, duration, spreads, etc. based on market conditions.” Another poster rationalizes his choice of active small/mid cap managers as follows: “I am hoping I’ve picked a very smart manager to take advantage of the market for a little extra gain, at least to compensate for the higher fees that come with them.” The oft-repeated idea that active beats passive in bear markets finds expression in the confused poster who states that he likes index funds in bull markets and active funds when things are going down. As we have often pointed out, there is no such thing as “going”; we can only speak of where the market has gone. All of the beliefs expressed by these posters are easily refuted.
To see the overall failure of active management, a good place to start is the Standard and Poors Indices Versus Active Funds Scorecard (SPIVA ®) which provides performance comparisons corrected for survivorship bias and measures of style consistency for actively managed US equity, international equity, and fixed income mutual funds. For the five years ending June 30 th, 2011, 61% of small cap and 79% of mid cap funds failed to beat their S&P benchmark. The story gets no better for international/emerging markets funds where 72% failed to beat their S&P benchmark. The worst of all the categories is fixed income where 78% failed to beat their benchmark. So much for those managers who know how to adjust quality, duration, etc. based on market conditions. Note that this five year period includes one of the worst bear markets since the Depression, so the myth that active management shines in bear markets is officially busted. It is also important to note that for those managers that beat their S&P benchmark, we cannot reliably determine whether it was due to luck or skill. A recent article on ifa.com analyzed the ten-year records of 602 actively managed U.S. equity funds. Only 0.5% of these funds beat their risk-adjusted benchmark to a degree where we are at least 95% certain (t-statistic greater than two) that it was not due to chance alone. Of course, there was no reliable way to identify these funds at the beginning of the period. Furthermore, the S&P Persistence Scorecard shows that the number of funds that stay in the top half or quartile of their peer group from year-to-year is lower than what we expect from chance alone. This is strong evidence of both the efficiency of the market and the resulting inability of active managers to deliver consistent outperformance.
Using the Morningstar Direct database, IFA performed its own study of how actively managed funds have done vs. the passively managed DFA funds in categories outside of domestic large cap. The table below summarizes the results:
Performance of Active Funds vs. DFA Funds as of August 31, 2011
| |
US Small Blend |
US Small Cap Value |
International Value |
Emerging Markets |
| DFA Ticker |
DFSTX |
DFSVX
|
DFIVX |
DFEMX |
| Inception Month |
4/1992 |
4/1993 |
3/1994 |
5/1994 |
| # Funds at Beginning |
48 |
38 |
56 |
40 |
| # of Surviving Funds |
25 |
26 |
39 |
17 |
| Fund Survival % |
52.1% |
68.4% |
69.6%
|
42.5% |
# That Beat DFA
|
14 |
4 |
13 |
3 |
| Survived & Beat DFA% |
29.2%
|
10.5% |
23.2% |
7.5% |
|
# That Beat DFA
(with a t-stat>2)
|
0 |
0 |
0 |
0 |
Overall, only 19% of these active funds both survived and beat the corresponding DFA fund, and none of the 19% beat the DFA fund to the extent that we can rule out luck as the cause, based on the results of the statistical t-test which shows that none of them beat the DFA fund with at least a 95% level of certainty. This result speaks very poorly for active management. So few of them have generated returns that compensate for their higher fees, and nobody has demonstrated a reliable method for identifying them in advance.
Thankfully, not all of the posters on Morningstar.com have been suckered in by active managers. Aquinas hits on one of the key benefits of passive investing (promotion of good investor behavior) when he says, “For many years, I used actively managed funds in my retirement accounts. But I have gradually switched to passively managed funds. Why? No style drift. Minimal portfolio turnover. Low fees. No worry that a star fund manager will quit, retire, get sick, or take a leave. And, most importantly, there is less temptation for me to chase returns, which almost always means selling low and buying high. Passive funds have a set-it-and-forget-it simplicity that lets me sleep soundly."
Cyberusandmag has the right idea when he says, “I believe that even talented managers are not able to consistently beat the market. If there are such managers, I am unable to identify them for future results. I also find that low costs with index funds (some) lead to better returns over time. I am invested entirely in index funds and follow a buy, hold, and rebalance strategy. It has worked for me."
Finally, Darwinian finds one good use for actively managed funds. “I use passively managed funds (Vanguard, DFA) to invest my money. I use active funds for the purpose of comparing expenses and turnover, so I can continue to feel happy about sending my money to Vanguard and DFA."
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