Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show “The ETF Store Show“.
One of the great, age-old debates in investing is whether to use active or passive (index-based) investments when building a portfolio. When investing in mutual funds and ETFs, investors typically fall squarely into one of three camps: they invest strictly in active funds, they invest only in passive funds, or they use a combination of the two. At the heart of this debate are two simple questions: 1) Can active fund managers consistently beat “the market” after their fees? 2) If active fund managers can consistently beat “the market”, can investors actually identify those managers in advance? Staunch supporters of active management obviously believe the answer to both of these questions is a resounding “yes”. The good news for investors is we actually have the data to answer these questions. More on that in just a moment.
Before we get to the data, let’s walk through a basic example of both active and passive management. If a fund is actively managed, a fund manager must decide which stocks, bonds, or other investments to buy and sell for the fund. For example, a manager of a large cap US stock fund might determine whether to own stocks such as Microsoft, Exxon, or GE, and how much of each to buy. If a fund is passively managed, it’s simply tracking an index that already exists. A passive large cap US stock fund might buy every stock represented in the S&P 500 index in the same weight as the index. There’s not a manager making decisions on which stocks to own and in what quantities.
It’s been my experience that many investors will consider the basic example above and conclude that they would prefer an active manager. After all, it seems like a much better option to hire a smart, Harvard-educated MBA who can find good stocks and avoid bad ones. Intuitively, this makes sense – until you consider the data. S&P Dow Jones Indices, the world’s leading provider of indices, constructs something called the SPIVA Scorecard which compares the performance of those indices to their actively managed mutual fund counterparts. The underperformance of active managers is astounding. Consider that over the five-year period ended 2012, 70% of all domestic equity funds underperformed their relevant benchmarks. Another study was recently conducted by Vanguard, who analyzed all actively managed US equity funds that existed in 1998 and through the end of 2012. Out of those 1,540 funds, 698 of the funds closed (likely because of underperformance), 567 funds survived but underperformed their benchmarks, and 275 funds survived and outperformed their benchmarks. In other words, more than 80% of the funds either closed and/or underperformed!
That might be enough to make most investors reconsider active management, but there’s more. Some investors and advisors hang their hat on trying to select the minority of active fund managers who might outperform in any given year. The thought process goes a little something like this: “I agree that the vast majority of active managers underperform, but I have the ability to select the managers who will outperform”. Again, let’s take a look at some data. S&P Dow Jones Indices also measures the persistency of active manager performance. In other words, is a manager able to consistently deliver performance? Over the five-year period ended July 2013, only 3.59% of all domestic fund active managers were able to maintain a top half ranking over five consecutive 12-month periods. Similarly, the Vanguard study found that out of the 275 outperforming funds mentioned above, 97% experienced at least five calendar years where they underperformed their benchmarks. It seems highly unlikely that investors and advisors are going to be able to identify the roughly 3% of active mutual funds that avoid this underperformance. As a matter of fact, Dalbar, Inc., a leading market research firm, found that for the 20 years ended 2012, the average investor in stock mutual funds earned an annualized return of only 4.25% compared with 8.21% for the S&P 500 Index.
The takeaway here is the vast majority of active mutual funds underperform their benchmarks. Additionally, the funds that may outperform in any given year are typically unable to maintain that outperformance. You may be asking yourself why extremely smart, highly educated, well paid managers have such poor track records. After all, they’re getting paid very well to deliver outsized returns. There are a number of reasons for this underperformance, but the single biggest reason is high fees. The average actively managed domestic mutual fund charges 1.41% annually (this is commonly referred to as the expense ratio). This means the fund manager must beat their benchmark by an average of 1.41% just to get even with that benchmark. That’s a tough proposition. Along with the expense ratio, the internal costs of running a mutual fund – things like trading commissions, market impact costs, and bid-ask spreads – can also negatively impact performance. This hidden overhead can actually end up being a greater cost to investors than the expense ratio itself.
Another major problem with active management is there are only so many truly wonderful investment opportunities available (and those opportunities are fleeting). If a fund manager shows any knack for identifying these opportunities, investors will flock to the fund. More investors mean more money that the fund manager has to invest. But with only so many good opportunities available, the fund manager may have to start moving downstream and investing in less attractive options. Or, they simply may not be nimble enough to take advantage of these short-lived opportunities. Issues such as these can quickly bring a once high-flying fund back down to earth. There are other reasons for mutual fund underperformance, but regardless (and for the sake of time), even if there was a fund manager who could outperform the market in a given year, how are you or your advisor going to find that manager? I would opine that you would need the same crystal ball that the “outperforming” fund manager has at their disposal.
At The ETF Store, we believe the best way to build an investment portfolio is through low cost, passively managed ETFs that will capture the bulk of the benchmark returns and limit the risk of manager underperformance. We attempt to deliver higher risk-adjusted returns to our clients through proper asset allocation decisions (i.e. what % of US stocks to own, what % of international stocks, % of bonds, etc). There have been numerous studies concluding over 90% of the variability of investor returns are due to asset allocation decisions, not the selection of the right mutual fund manager or the next hot stock. Now, you may be saying to yourself, “Aren’t asset allocation decisions the same as active management”? The answer to that question is certainly “yes”, but somebody ultimately has to determine the right mix of investments in a portfolio. Asset allocation decisions are unavoidable, whether you’re using actively managed or passively managed funds. The question is, “What is the best way to gain exposure to a particular asset class”? We prefer to minimize or eliminate the active manager risk in this process and use inexpensive, index-based ETFs.
One last note – I mentioned there was a third camp of investors who advocate using both active and passive investments to build portfolios. The theory goes that active management is particularly useful for certain asset classes – say for municipal bonds or high yield bonds. The concern with this approach is asset classes such as these still suffer from the same active manager underperformance as other asset classes (SPIVA shows high yield funds have underperformed almost 94% of the time and general municipal debt funds nearly 64% of the time over the five years ending 2012). If you’re in this third camp, not only do you have to pick the active managers who will outperform and the ones who will outperform consistently, you now have to pick the right asset classes from which to choose these managers! I would contend this is an even more difficult proposition and would require an even larger crystal ball.
At The ETF Store, we value our ability to select whatever we believe is the best investment to represent a given asset class. Active funds are invariably a part of the total investment universe from which we have to draw. As stewards of our clients’ assets, it’s our job and duty to consider all investments and we would never rule out using an active fund if we thought it could provide the best exposure to an asset class we wished to invest in. However, up to this point, while we’ve been searching for that fund, quite frankly, we have yet to find it.
