John Spence

S&P Takes Active vs. Passive Debate to New Level with Quarterly Fund Scorecard

Standard & Poor's says it will begin keeping tabs on nearly 2,000 actively managed mutual funds to measure how they stack up against relevant S&P indexes. The new quarterly scorecard will use more sophisticated techniques to give investors a clearer picture of how active funds are performing relative to their benchmarks.

For example, S&P's methodology takes into account "survivorship bias," or the fact that many poor-performing mutual funds are liquidated or merged out of existence. Most comparative studies don't adjust for fund survivorship bias, which may skew the results in favor of active funds. S&P found that for the 12 months preceding October 2002, 6.5% of all funds have been liquidated or merged. Over the past five years, 16.2% of all funds bit the dust.

S&P will also keep track of asset-weighted returns for each fund group, which may give a better idea of how much performance investors are getting for their dollars. Most active vs. passive comparisons are equal-weighted, in which small funds count as much as larger funds with more assets under management. S&P's asset-weighted fund group returns aren't encouraging for active fund investors. Over the past five years, asset-weighted returns for large-, mid-, and small-cap funds have been worse than equal-weighted returns.

The five-year period examined in the current S&P scorecard represents an interesting test case because it includes the tail end of the bull market of the late 1990s, as well as the wrenching bear market of the past two and a half years.

Many advisors and analysts say indexing makes the most sense in the efficient large-cap arena. For the five-year period ending September 2002, the S&P 500 outperformed over 63% of all large-cap funds. However, large-cap funds have made a comeback during the bear market, with 54% besting the index over the past three years.

In the mid-cap territory, it's a landslide victory for the S&P MidCap 400, which outperformed 93% of all mid-cap funds over the five-year period and 83% over the last three years. The index's dominance here is largely due to the fact that S&P requires four consecutive quarters of positive earnings to be eligible for the index. Therefore, the S&P MidCap 400 shunned IPOs and other speculative stocks that moved to mid-cap levels. Also, many mid-cap managers shop in the small-cap territory - they also tend to hold mid-cap stocks that move into the large-cap classification. However, they would have generally been better served staying strictly within the confines of an outperforming mid-cap asset class.

Many point to the supposed inefficiency of the small-cap asset class as an example where active funds should have a leg up on the index. However, S&P found that small-cap managers have a tough time besting the S&P SmallCap 600. The index outperformed 67% of funds over the five-year period, and 71% over the past three years. Again, S&P's profitability requirements helped avoid the carnage in small-caps when the technology bubble burst in 2000. The S&P 600 has also gotten the better of its competitor index, the Russell 2000 - we'll compare these two small-cap benchmarks in an upcoming article.

The table below shows asset-weighted average fund performance for various categories against the relevant S&P index. The full report is available on the S&P website.