Larry Swedroe

The Road Less Travelled

As they begin their journey, investors are faced with an immediate fork in the road-the choice between an active and a passive management strategy. Given the substantial body of evidence it seems clear that passive investing is the strategy most likely to deliver superior results.

Exhaustive studies have shown that over the long term the average actively managed fund has underperformed its appropriate passive benchmark by about 1.8% per annum on a pretax basis (taking taxes into account would increase this figure to approximately 3%). Despite this evidence, the vast majority of individual investors travel the active path. Only about 10% of all individual funds are currently invested in passive funds.

The winter issue of the Journal of Private Portfolio Management contained a study that looked at the odds of active managers outperforming. The study looked at all 307 large-cap funds with at least a 10-year history. This methodology creates what is known as survivorship bias in favor of active management. Funds that perform poorly close because of redemptions by investors, or they are merged out of existence by their sponsor. Thus their performance data disappears. The returns of the funds were then compared to that of the benchmark S&P 500 Index. Over the 20-year period the passive strategy outperformed over 93% of all surviving funds. For the 15-year period it outperformed over 99% of all surviving funds. And, for ten-, seven-, five-, and three-years periods the passive strategy outperformed at least 95% of all surviving active funds. Finally, for the 61 rolling five-year periods the passive strategy outperformed at least half the active funds 58 (95%) times. And, all this is on pretax basis. Based on historical data it is safe to assume that the results would have been even worse if the returns had been measured on an after-tax basis.

The actual returns earned by investors in these actively managed funds was in all likelihood even worse. The reason is the study assumed that investors earned the same returns as the funds in which they invested. Several studies have found that investors actually earn far less than the funds in which they invest because they chase returns. They tend to buy a fund after it has performed well, and sell it after it has done poorly. This results in a buy high, sell low outcomenot exactly a prescription for success. The studies have found that investors underperform their own funds by between 5 and 10% per annum.

Clearly, on average investors in actively managed funds were choosing the wrong strategy. Simply accepting market returns would have improved their collective results dramatically. The usual counter argument from the active management faithful is that “I don’t buy the average fund. I only buy the funds that have great performance.” Unfortunately, there is a huge body of evidence that demonstrates that you cannot rely on past performance of active managers as an indicator of future performance. It is simply a very poor indicator. One example of the fallibility of relying on past success is the findings of Bill Bernstein. Relying on the Micropal database, he examined the performance of the top 30 funds for successive five years being in 1970, and then compared their performance against that of the S&P 500 Index through 1998. Here is what he found:

• The top 30 funds from 1970 through 197 4 went on to underperform the Index by 0.99% per annum.
• The top 30 funds from 1975 through 1979 went on to underperform by 1.89% per annum.
• The top 30 funds from 1980 through 1984 went on to underperform by 2.75% per annum.
• The top 30 funds from 1985 through 1989 then went on to underperform by 1.57% per annum.
• The top 30 funds from 1990 through 1994 then went on to underperform by 10.9% per annum.

In not one case did the top performers from one five-year period continue to outperform. Since past performance is not an indicator of future performance, it seems that investors are simply being fooled by randomness. With so many players in the performance game, there are likely to be some winners over any time frame. The evidence, however, suggests that while investors attribute skill to the winning result, it appears to be much more likely to be an outcome that was randomly generated, and thus not likely to be repeated.

The conclusion we draw is that the prudent strategy, the one most likely to generate superior returns is the passive one. The American Law Institute (ALI) came to the same conclusion when in their third rewrite of the Prudent Investor Rule they adopted Modern Portfolio Theory and passive investing as they standard by which fiduciaries should be guided. This rewrite has since been adopted into law by almost every state. Here are a few conclusions the ALI drew.

• Economic evidence shows that the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in market prices.
• Fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to “beat the market” ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs.
• Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under-priced securities with any regularity.
• Evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.

Active management does hold out the hope of outperformance. This hope is what Wall Street and the financial press sells. Unfortunately, the odds of winning that game have proven to be so low that unless one attaches a high value to the entertainment of the effort (the “thrill of the kill,” and the bragging rights that go with it), then it doesn’t pay to play. The winning strategy is passive investing. Thus we suggest that when you come to that fork in the road, travel the road less traveled (at least so far), it is far more likely to get you to your destination (a better financial future).

Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know" and "The Only Guide To A Winning Investment Strategy You Will Ever Need." He is also the Director of Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.