Large-scale studies have shown that actively managed funds underperform their passive benchmarks on an absolute basis. New research shows that this is also true on a risk-adjusted basis – and this is true across asset classes and sub-classes.
Since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) scorecard, which compares the performance of actively managed equity mutual funds to their appropriate index benchmarks. While their SPIVA scorecards persistently demonstrate that large majorities of active funds underperform their benchmarks (even before considering taxes) in absolute returns, they do not address the claim that active funds may be superior to passive investment after adjusting for risk. With that in mind, using standard deviation as the measure of risk, they developed a risk-adjusted scorecard.
Following is a summary of their 2019 report:
- Over the last five-, 10- and 15-year periods, 84%, 97% and 92%, respectively, of actively managed large-cap funds underperformed their benchmarks.
- Over the last five-, 10- and 15-year periods, 65%, 80% and 86% of actively managed mid-cap funds underperformed their benchmarks.
- Over the last five- , 10- and 15-year periods, 77%, 89% and 87% of actively managed small-cap funds underperformed their benchmarks – exposing the myth that active management works in the supposedly inefficient asset class of small-cap stocks.
- As in the U.S., the majority of international equity funds across all categories generated lower risk-adjusted returns than their benchmarks. For example, over the five-, 10- and 15-year periods, 75%, 80% and 89% of actively managed emerging market funds underperformed – exposing another myth that active management works in the supposedly inefficient asset class of emerging markets. Similar results were found with international small-cap funds, where 78%, 63% and 68% underperformed.
- A large majority of actively managed fixed-income funds in most categories underperformed over all three investment horizons. At the 15-year horizon at least 60% of active funds underperformed in all categories, and in only two of 14 categories fewer than 78% underperformed. The worst performance came in the supposedly inefficient asset class of emerging-market debt, where over 10- and 15-year periods not a single active fund outperformed. Over the five-year period, 98% failed to outperform.
The authors concluded: “We did not see evidence that actively managed funds were better risk-managed than passive indices. Actively managed domestic and international equity funds across almost all categories did not outperform the benchmarks on a risk-adjusted basis.”
These findings are consistent with those from academic research on the question of persistence in performance. For example, the study by Eugene Fama and Kenneth French, Luck versus Skill in the Cross-Section of Mutual Fund Returns, published in the October 2010 issue of The Journal of Finance, 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. Stated differently, the very best-performing traditional active managers have delivered returns in excess of the Fama-French three-factor model. However, their returns have not been high enough to be confident in concluding they have enough skill to cover their costs or that their past performance will persist. Fama and French concluded: “For (active) fund investors the simulation results are disheartening.”
Similar results were found by Philipp Meyer-Brauns of Dimensional Fund Advisors in his August 2016 study, Mutual Fund Performance through a Five-Factor Lens. He found an average negative monthly alpha of fund performance 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%). Meyer-Brauns concluded: “There is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.” He added that “funds do about as well as would be expected from extremely lucky funds in a zero-alpha world. This means that ex-ante, investors could not have expected any outperformance from these top performers.”
Meyer-Brauns extended his work in the March 2017 paper, Luck vs. Skill Across Different Fund Categories. He examined four separate categories of U.S. equity mutual funds (large-cap value, large-cap growth, small-cap value and small-cap growth) over the period January 2000 through June 2016. His goal was to determine whether the ability of active managers to outperform the Fama-French five-factor model varied across fund categories. He found that the best-performing funds perform no better than would be expected by chance alone in a zero-alpha world. For example, the by-chance distributions indicate that if all funds could cover their costs, slightly more than 2% should be expected to have alpha t-stats larger than 2. Looking at the actual distributions across fund categories, he found that in two of the four categories, large-cap value and large-cap growth, not a single fund had an alpha t-stat above 2. For the two other categories, small-cap value (1.8%) and small-cap growth (1.1%), the percentage was lower than would be expected by chance.
The research demonstrates that the vast majority of actively managed funds in all categories were unable to cover their costs, and that the persistence of outperformance among the few that did succeed has been less than we would randomly expect – the result being that relying on past performance is what Charles Ellis famously called “the loser’s game.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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