The US has always been seen as a region where passives do well. The conventional thinking is that there are thousands of analysts and investment managers covering the stocks in the S&P 500, so the stocks should be pretty efficiently priced. Unsurprisingly, that seems to be the case, with passives trouncing their active counterparts over the last 15 years. The extent of the underperformance was, however, more surprising, with one of the most interesting findings being that passives outperformed in all three years where the market crashed.
- Over the last 15 years, across both S&P and Morningstar, 84% of all domestic US active equity funds underperformed their benchmark. This includes the period before 2008, which counters the idea that passives have only done well thanks to QE in the years since the financial crisis.
- After adjusting for risk, the numbers get even worse for active funds, with 95% of all domestic US active equity funds underperforming their benchmark over the last 15 years on a risk-adjusted basis.
- Passives’ outperformance included the years where the market crashed – 2001, 2002, and 2008. This goes against the idea that active managers are able to anticipate market crashes and use that knowledge to better protect investors’ portfolios.
- Passives also outperformed in the supposedly less efficient small cap space, with 98% of active US small cap funds underperforming over 15 years according to S&P, and 82% of small cap funds underperforming according to Morningstar. There does not seem to be any evidence of US small caps being more favourable for active managers.
- The underperformance of US active funds has also been corroborated by research from DFA, Lyxor, Vanguard, Fama and French (after adjusting for factor exposure), and the University of Toronto.
Section 1 of this post focuses on 2 sources of data: the Morningstar Active/Passive Barometer and the SPIVA reports. Both reports are updated every 6 months, and are cited widely in the industry as being the “scorecard” for assessing the performance of active funds. Both studies are conducted independently using their own separate data sets.
Section 2 contains a selection of other recent relevant studies that also contribute to the active/passive performance debate. Despite not being updated as regularly as the Morningstar and SPIVA reports, their conclusions are equally worth reading.
The Morningstar Active/Passive Barometer and the SPIVA reports
This section summarises the performance of active funds in the US over the last 15 years, relative to their passive benchmarks. There is considerably more data in the underlying reports, which can be found here, here, and here.
- The combination of most active funds failing to survive, combined with most active funds underperforming their benchmark, has meant that fewer than 15% of active funds both survived and outperformed their passive benchmark over the 15 year period.
- Small cap active funds have had a higher survival rate, but also had a higher level of underperformance vs the benchmark, meaning their overall results for surviving and outperforming were actually lower than large-cap funds.
- When adjusting for risk, the results are even worse for US active funds, with fewer than 5% of active funds surviving and outperforming on a risk-adjusted basis.
- Over 50% of US active funds underperformed their benchmarks in 11 of the last 17 calendar years,
- Contrary to popular belief, active funds did not perform better during years where the market performed badly:
- In 2001, when the market fell 12%, 55% of active funds underperformed
- In 2002, when the market fell 22%, 58% of active funds underperformed
- In 2009, when the market fell 37%, 65% of active funds underperformed
NB: S&P Dow Jones compares active funds’ performances against their S&P-assigned costless benchmark, based on the funds’ Lipper classifications. Morningstar compares active funds’ performances against a composite of actual passive funds – their “benchmark” reflects the actual, net-of-fees performance of passive funds.
NB: Standard deviation of monthly returns, over a given period, is used to define and measure risk. The return/risk ratio is used to evaluate managers’ risk-adjusted performance. Returns of the benchmarks are also adjusted by their volatility.
NB: Survivorship is calculated by dividing the number of distinct funds that started and ended the period in question by the total number of funds that existed at the onset of the period in question (the beginning of the trailing one-, three-, five- and 10-year period)
Calendar year performance
Further evidence from other sources
Dimensional Fund Advisors
DFA’s 2018 Mutual Fund Landscape report shows that over 15 years, just 14% of active US equity funds survived and outperformed their benchmark:
Dimensional Fund Advisors no. 2
In the research paper “Mutual Fund Performance through a Five-Factor Lens,” by Philipp Meyer-Brauns of Dimensional Fund Advisors, the researchers sample 3,870 active funds over the 32-year period 1984 to 2015 in order to determine how much of the returns from US active equity managers could be explained by Fama French’s 5 factor model. The auther concluded that under 3% of active US equity funds showed signs of statistically significant alpha over and above the 5 factor model. Whilst the underlying paper is behind a DFA paywall, the results are summarised in the article below.
“Benchmarking their returns against the newer Fama-French five-factor model (which adds profitability and investment to beta, size and value), he found an average negative monthly alpha of -0.06% (with a t-stat of 2.3). He also found that about 2.4% of the funds had alpha t-stats of 2 or greater, which is slightly fewer than what we would expect by chance (2.9%).”
Vanguard’s research paper, ‘The case for low cost index-fund investing’ shows on page 9 how between 60% and 90% of active funds underperformed their benchmarks over the last 15 years across all measured regions:
Lyxor’s research paper, ‘Analysing active & passive performance: What 2017 results tell us about portfolio construction’ shows on page 25 that between 11% and 50% of active equity funds outperformed their benchmark over the last 10 years – with well under 50% of active European equity funds outperforming:
Research from Morningstar suggests that active funds, in aggregate, outperform passives pre-fees. But 1) the excess returns were consumed by fees, 2) the active funds only outperformed in aggregate – there was still the real risk that an individual fund closed, and 3) you would have outperformed only if you owned all the funds, kept costs low, and stayed the course – I.e. invested like a passive index investor:
“…over the trailing 20 years ended Sept. 30, 2018, the average dollar invested in U.S. stock funds outperformed its blended index and 80% of other funds before fees. This phenomenon was not exploitable, as investors couldn’t purchase every fund and fees consumed all of the alpha the average dollar generated. In addition, the average dollar’s outperformance margin narrowed through the years. This serves as a reminder that active managers can be skilled in aggregate yet still fail to deliver value. In some respects, the best way to beat the index is to act like the index.”
Qiang Bu – The Journal of Wealth Management
Qiang Bu, an associate professor of finance in the School of Business Administration at Pennsylvania State University-Harrisburg, examined whether long-term fund alphas come from manager skill or luck. His study covered the 20-year period 1993 to 2012, and found that only 8 funds produced statistically significant alpha, out of the more than 1,000 active funds that existed at the start of the 20-year period. Whilst the paper itself is behind a paywall, Larry Swedroe produced an excellent commentary on ETF.com (link below).
“Bu’s finding that only eight of the thousands of funds that existed at the start of his sample period managed to produce statistically significant alphas is pretty damning evidence against the likelihood of an investor selecting actively managed funds that will outperform.
In addition, while the eight winners averaged a very impressive annual alpha of 3.3%, over the more recent, 15-year period we examined, they provided pre-tax returns just 0.2 percentage points higher than a low-cost, highly tax-efficient portfolio of indexed ETFs.”:
Fama and French – The Journal of Finance
Academic investing legends Eugene Fama and Kenneth French examine the returns of US active mutual funds since 1983, and find that mutual fund investors in aggregate realise net returns that underperform CAPM, the three-factor, and four-factor benchmarks by about the costs in expense ratios. They found fewer active managers (about 2%) were able to outperform their three-factor (beta, size and value)-model benchmark than would be expected by chance.
“This suggests that some managers do have sufficient skill to cover costs. But the estimate of net return three-factor true α is about zero even for the portfolio of funds in the top percentiles of historical three-factor t(α) estimates, and the estimate of four-factor true α is negative”
Sebastian and Attaluri – The Journal of Portfolio Management
This article in a 2014 issue of the Journal of Portfolio Management shows that the percentage of skilled managers (those showing net alphas – demonstrating enough skill to more than cover their costs), began the period at about 10%, rose to as high as about 20% in 1993, and by 2011 had fallen to just 1.6%, virtually matching the results of the aforementioned paper by Fama and French.
“They find that less than 2% of products exhibited evidence of skill over the time period. The authors argue that institutional investors spend far more resources on selecting and monitoring active managers than is warranted by the results, either in terms of portfolio results (contribution to risk) or added value.”
S&P Dow Jones
In addition to the SPIVA reports discussed in Section 1, S&P Dow Jones have also looked specifically at how fees affect the active vs passive debate in their “SPIVA® Institutional Scorecard”. The report finds that most active US equity managers actually underperform before fees too – 60% to 85% of US equity mutual funds/institutional accounts underperformed their benchmark before fees:
In a typically excellent 2018 paper by AQR, they present data that shows active managers across 5 universes outperforming their benchmarks net of fees. Whilst the main paper compares performance versus the benchmark, the companion paper adjusts for active managers’ risk taken compared to the benchmark. The studies show that active managers have added value net of fees, both before and after adjusting for risk (but after adjusting for risk, all the institutional fixed income alpha disappears, and hedge fund alpha is cut in half).
However, a few important caveats are noted: 1) survivorship/backfill biases are a problem, particularly for the hedge fund reported returns, but also for institutional equities, which may result in returns being overstated (“However, these long-run results may be overstated or even largely explained by selection biases; further research is needed to quantify their impact”), and 2) despite making adjustments to the private equity’s risk level to account for their smoothed returns as a result of reporting appraisal and IRR-based returns, their beta is still likely too low, resulting in a likely overstated risk-adjusted return.
They also find that active managers have outperformed in supposedly less efficient markets, such as international and small cap spaces, but also note that “One counterargument is that these dusty corners have higher fees, and they, too, have active losers. Since every investor cannot pick a top-quartile manager, active managers’ aggregate net performance could actually be worse in such high-fee contexts”, and also that these “dusty corners also have less data and potentially greater reporting biases”.
Key table (from companion paper – risk-adjusted returns):
University of Toronto
3 researchers from US universities published a controversial paper entitled “Cheaper Is Not Better: On the Superior Performance of High-Fee Mutual Funds”, arguing that high fee funds actually outperform low-fee funds – not just before fees, but after fees as well. This outperformance only comes, however, after adjusting for high-fee funds’ exposure to low profitability and high investment rate factors – both of which suggest negative excess returns under the Fama-French 5 Factor model. I.e. high-fee funds are effectively handicapping themselves by allocating to factors with negative expected excess returns.
Morningstar then responded to the paper, arguing that 1) investors in the high-fee funds are still receiving lower returns than low-fee funds. The factor explanation for why the returns are lower are unlikely to be of interest to investors in the real world, who are still receiving less than if they’d invested in cheaper funds. 2) the results applied to US equity funds only (not international funds, bond funds, or any other asset classes)
“High-fee funds exhibit a strong preference for stocks with low operating profitability and high investment rates, characteristics recently found to associate with low expected returns. We show that after controlling for exposures to profitability and investment factors, high-fee funds significantly outperform low-fee funds before expenses, and perform equally well net of fees”
“In practice, because high-cost U.S. stock funds are hurt by both their extra expenses and their investment leanings, they have lower total returns than do cheaper funds. They have made more money for CNB’s five-factor alpha calculation, but less money for living, breathing shareholders. That won’t change, unless such high-cost funds break their 40-year habit and invest in companies with different characteristics, or low-profit, high-investment firms confound both logic and history by performing well. Neither possibility seems likely.
In summary, there’s no real-world justification for owning expensive funds. CNB’s definition of success does not match those of investors. What’s more, its conclusions, such as they are, hold only for U.S. equity funds.”
Robert Kosowski of INSEAD’s finance department suggests in his 2006 paper that active funds have historically been able to add alpha in recessions. Whilst I have no reason to doubt the author’s conclusions, it should be noted that a recession is not the same as a bear market or market correction. The author uses the NBER’s definition for what constitutes a recession, which is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
There have been numerous examples in US history where bear markets have not been accompanied by recessions, and where recessions have not been accompanied by bear markets. For reference, the dark yellow table at the bottom of this FT article explains the relationship well (plus a couple of good articles from one of my favourite writers, Ben Carlson of Ritholtz Wealth Management here and here). It also highlights that the relationship, whilst closer in the US, does not hold up particularly well in other markets. As the INSEAD study focuses on US domestic equity mutual funds, there is no evidence of their outperformance outside the US.
“...while in expansion periods there is evidence of underperformance, in recession periods US domestic equity mutual funds provide investors with a diversified equity position without underperforming the relevant benchmarks. Thus the common finding of negative return performance at US domestic open-end mutual funds is attributable to expansion and not recession periods, when performance matters most to investors.”