I thank Mr. Murphy and Mr. Broadhurst for their comments.
I do not take a position in the active versus passive debate. For example, I wrote an article last August, Luck versus Skill in Active Mutual Funds, that highlights new research in support of the passive side of the debate. You can also read the interviews I have done with John Bogle, Burton Malkiel, William Sharpe and Ken French, all of whom advocate passive investing.
SPIVA does not attempt to answer the question of whether skillful active managers can be identified in advance. Personally, I believe the percentage of skillful active managers is less than the SPIVA study might lead one to believe.
I would like nothing more than to publish the results of a carefully researched, methodologically precise defense of either passive or active management. When S&P published its SPIVA study with claims of the superiority of its own index products, it called for scrutiny. My conclusion remains that S&P’s methodology is insufficiently rigorous to justify its conclusions.
The third bullet point referenced in Mr. Broadhurst’s letter is very important. S&P claims all US equity active managers underperformed its passive index by 221 basis points. If the index and the active investors were fully invested (no cash), this difference should equal fees and costs, as dictated by William Sharpe’s “The Arithmetic of Active Management.” In this article, Sharpe states “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
The average mutual fund expense ratio is 80 basis points, leaving 141 basis points unexplained. Active managers hold more cash than passive indices, so the real difference in a bear market is more than 141 basis points (holding cash improved the performance of active managers). S&P needs to account for this inconsistency before I can accept their results.
The SPIVA study’s primary conclusion was that passive management beats active management to a greater degree in bear markets. Even if I were to accept S&P’s equal-weighting methodology, the use of its own index products as the benchmark, and the impurities in its data, this primary conclusion would remain unsupported. The broad-based market data clearly show a weak and statistically insignificant inverse relationship between market and passive index performance.
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