When Luck Runs Out - The Success Rate of Active Management
This St. Patrick’s Day, we have luck on our minds. But in the world of investing, how lucky can you really be?
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 43% of U.S. equity mutual fund and ETF investments, up from 20% in 2011 and 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.
We make decisions based on objective data and evidence (and not the general flow of capital), and one report we eagerly await is the bi-annual S&P Dow Jones Indices SPIVA (S&P Indices Versus Active) 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 of how well active managers are doing their jobs.
The most recent SPIVA Scorecard was released for Mid-Year 2022. S&P Dow Jones is now 20 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, 87% or more of the U.S. fund managers underperformed their benchmarks (see table below).
The Repeated Success Rate for Active Management is Even Worse
But maybe you know of an extraordinary stock broker or fund manager or TV personality who strikes you as being among the elite few who can make the leap. Maybe they have a stellar track record, impeccable credentials, a secret sauce, or brand-name recognition. Should you turn to them for the latest market tips, instead of settling for “average” returns?
Let’s set aside market theory for a moment and consider what has actually been working. If investors were able to depend on outperforming experts, we should expect to see credible evidence of it. Not only is such data lacking, but the body of evidence to the contrary is also overwhelming. Star performers – “active managers” – often fail to survive, let alone persistently beat comparable market returns.
To cite one of many sources, Morningstar publishes a semiannual Active/Passive Barometer report, comparing actively managed funds to their passively managed peers. In its most recent September 2022 report, Morningstar found: “In general, actively managed funds have failed to survive and beat their average passive peer, especially over longer time horizons; one out of every four active funds topped the average of their passive rivals over the 10-year period ended June 2022”
Dimensional Fund Advisors found similar results in its independent analysis of 10-year mutual fund performance through year-end 2021. On average, only 21% of equity funds maintained top-quartile performance 5 years in a row, and 31% of fixed-income funds.
Why do strong track records fail to persist? The efficiency of the market is tough to consistently overcome. In addition, high costs and excessive turnover contribute to underperformance.
The Bottom Line
It is really hard to beat an index. If you or your advisor are pursuing traditional active management, you’ll need to depend on some luck.
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 make decisions based on data and evidence. That is also why we 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.
The decisions you or your financial advisor 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.
If you need help making these decisions, contact us.
