Twice each year, Standard & Poor's puts out its active versus passive investor scorecard, reporting on how actively managed funds have done against their respective benchmark indexes. Every time, the results are pretty much the same, demonstrating that active management is a loser's game -- in aggregate those playing leave on the table tens of billions of dollars forever seeking alpha (outperformance, adjusted for risk).
S&P's latest Indices Versus Active Scorecard focused its attention on the issue of the persistence of performance. It contained no surprises. In fact, one of the major findings was that for the five years ending March 2012, the percentage of top-performing managers remaining in the top-half or top-quartile declined considerably in several categories. In other words, when persistent performance was needed most (because of the very poor performance of the markets), the historically poor persistence actually got worse. The following is a summary of the scorecard's findings:
- For the five years ending March 2012, only 5.2 percent of large-cap funds, 5.5 percent of mid-cap funds, and 5.1 percent of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. That's less than the 6.25 percent rate we would expect from a purely random outcome.
- Just 6 percent of large-cap funds, 4.4 percent of mid-caps funds, and 15.6 percent of small-cap funds with a top-quartile ranking over the five years ending March 2007 maintained a top-quartile ranking over the next five years. Randomly, we would expect a repeat rate of 25 percent.
- The only place that there is persistence beyond the randomly expected is in the bottom quartile of funds. Across all market cap categories and all periods studied, fourth-quartile funds had a much higher rate of being merged and liquidated. It's not that the fund managers are dumb or unlucky. Instead, it's that the bottom-quartile funds repeat because of the burden of their high expenses. The figures are so bad they surprised even me. Looking at two overlapping three-year periods, depending on the fund category, between 22 percent and 33 percent of funds in the bottom quartile were either merged out of existence or liquidated. When we extend the time frame to overlapping five-year periods, the percent merged or liquidated jumps to between 33 percent and 42 percent. When looking at the bottom half it doesn't get much better -- the percent that were merged or liquidated ranged from 20 to 25 percent. Using five-year overlapping periods, the percent merged or liquidated was between 29 percent and 34 percent.
- As another challenge to active management, a significant percent of funds changed styles over succeeding three-year periods -- creating the risk of style drift for investors, which causes them to lose control over the risk of their portfolio. Breaking the funds into performance quartiles, between 7 percent and 14 percent of large-cap funds changed styles; between 24 percent and 34 percent of mid-cap funds changed styles; between 2 percent and 10 percent of small-cap funds changed style; and between 18 and 28 percent of multi-cap funds changed style.
These findings are consistent with the academic research. For example, economist Eugene Fama and finance expert Ken French studied the topic of performance persistence in their 2009 paper, "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates." Using statistical analysis, they found that active managers as a group haven't added any value over appropriate passive benchmarks. They concluded: "For (active) fund investors the simulation results are disheartening." They did concede that the results look better when looking at gross returns (that is, the returns without the expense ratio included). However, gross returns are irrelevant to investors unless they can find an active manager willing to work for free.
Bradford Cornell also contributed to the literature with his 2009 study, "Luck, Skill and Investment Performance." He reached the conclusion that "most of the annual variation in performance is due to luck, not skill. The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill."
Obviously, the majority of investors in active funds are taking all the risks of investing and not being properly rewarded for taking those risks, transferring tens of billions from their accounts to the wallets of active managers. The question is why do they keep doing this? Evidence suggests that one explanation is that they are simply unaware of how poorly they are doing.
Another explanation is that hope springs eternal. The historical evidence makes clear that because past performance of a fund has virtually no value as a predictor of future performance (except that the high expense bottom-quartile funds tend to repeat), when choosing a fund your focus should be on its expense ratio, the structure of the fund, its turnover, and its tax efficiency.
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