Gambling on Active Management? The Odds are Against You.

Most of us are competitive, and few of us take pleasure in losing. Although, if we lose to a superior competitor, like Roger Federer in tennis or Tiger Woods in golf, it may be quite satisfying and memorable. Yet, when it comes to investing, losing can be frustrating and expensive. And it certainly isn’t satisfying.

Passive Management is Growing

A long battle has been raging between traditional active management (e.g. stock picking) and passive management (e.g. index funds). If you were to judge the battle by where the money has been flowing, then clearly passive has been the recent winner. According to the Investment Company Institute, index funds now represent around 28% of U.S. equity mutual fund and ETF investments, up from less than 4% in 1993. There are similar trends with international funds and hybrid/bond funds, although not quite as pervasive.

These trends are fascinating as the flow of capital has been pitted against a significant amount of energy that goes into the promotion of “traditional active” management. Each stock picker wants you to believe he/she is the next Warren Buffett, Peter Lynch, or Bill Miller. Short-term results and Morningstar Ratings are touted in ads by fund companies. Radio and cable show commentators regularly share their investment strategies and latest stock picks hoping to lure you with their views. Honestly, these conversations are generally more interesting and exciting than a discussion about a boring index fund.

The Success Rate for Active Management is Downright Awful

Yet, despite this marketing hype, the trends speak loudly as investors are moving away from traditional active management. Why is this the case? The success rate for active managers has not been very good. In fact, it has been downright awful. So, kudos to investors for recognizing this and moving their money away from the hype-machines.

Since Kings Path seeks to make decisions based on objective data and evidence (and not the general flow of capital), one report we eagerly await is the bi-annual S&P Dow Jones Indices SPIVA Scorecard. This report provides an objective look at how traditional active fund managers are performing versus their respective indices over multiple time periods – essentially, a quick measure on how well active managers are doing their jobs.

Recently, the SPIVA Year-End 2017 U.S. Scorecard was released. S&P Dow Jones is now 17 years into measuring this “race,” which gives enough time to capture up and down markets, economic expansions and contractions, and many geopolitical events. What’s amazing is just how bad it has been for traditional active managers. Over any 3-, 5-, or 10-year period, 80% or more of the U.S. fund managers underperformed their benchmarks. That’s right, 4 out of 5 (and in most cases, 9 out of 10) failed to beat their respective public index (See table below).

Admittedly, the data does show some improvement in 2017, particularly in the small- and mid-cap segments. But, we also saw this in 2007 and 2009 only to see the majority of managers fail to meet expectations in subsequent years. Nevertheless, we will watch to see how these managers fare in 2018.

Percentage of Funds Underperforming their Benchmark:

Investors often make decisions based on commonly held beliefs or heuristics. One common mantra today appears to recognize the growing difficulty for traditional active managers to win. It goes like this: “Invest passively in US large cap as this space is highly competitive, transparent and liquid, but bet on active management in small cap, emerging markets and international where managers still provide value.”  While this is a nice theory, the recent data doesn’t seem to support this. Almost 90% of small cap managers and 70% or more of international and emerging markets managers have underperformed over the last 3-, 5-, and 10-years.

The Bottom Line

It is really hard to beat an index. If you or your adviser are pursuing traditional active management, the odds are stacked against you winning.

Kings Path doesn’t provide proprietary mutual fund or ETF products, so we don’t have any emotional or profit incentive for either active or passive implementations. But what we do want for our clients is to increase their chances of winning, and certainly decrease their chances of losing. For this reason, we love this report and other reports that help us make decisions based on data and evidence. That is also why we currently use risk factor-based solutions, which capture some of the benefits of indexing (e.g. low-costs, diversification) while maintaining the opportunity for “better than indexing” performance over the longer term through exposure to well-researched risk factors. Now, that is the subject of another blog!

The decisions you or your financial adviser make around the types of managers and investment strategies you invest in can make a big difference in your long-term returns. Make sure these decisions are based on data and evidence, and not emotions or poorly constructed beliefs.