Study puts another nail in active management's coffin

An ongoing debate among investors is whether an active or passive strategy is most likely to give you the best results. Twice a year, Standard & Poor's releases their active vs passive score card (officially called the S&P Indices Versus Active Fund report, or SPIVA for short.) The analysis compares actively managed funds against S&P index benchmarks, or put simply, different asset classes of active funds are pitted against their respective passive counterparts.

The SPIVA is important to investors because it shows that the past is not prologue. Investors cannot use past performance to identify which of the active funds will outperform in the future. Outperformance should be randomly expected, and the SPIVA shows why. Despite active managers claiming they can beat benchmarks, the data tell a different story. Today we'll report on some of the key findings from S&P's latest study.

First, S&P looked at the individual years covering the 10-year period 2004-13. They then took the average figure of the outperformance by the benchmarks for each of the 10 individual years. They found that in every domestic equity asset class, the majority of actively managed funds underperformed their appropriate index benchmark. The best performance was for actively managed large-cap growth funds, in which "just" 57 percent underperformed.

The worst performance was for small-cap growth funds, in which 67.2 percent underperformed -- and 66.8 of actively managed small-cap funds were outperformed, and 61.4 percent of actively managed small-cap value funds were outperformed. Interestingly, active managers make the case that they can outperform in the less efficient asset class of small caps. Yet active managers performed worse in small caps than they did in the more efficient large caps.

Second, over five-year periods the results were very similar. The majority of actively managed funds underperformed in every single domestic asset class. The "best" performance was in small-cap value stocks, with "just" 60.7 percent of actively managed funds underperforming. The worst performance was in REITs, where 80.3 percent underperformed. Looking at all large-cap, mid-cap and small-cap funds, 72.7 percent, 77.7 percent and 66.8 percent, respectively, underperformed.

Third, the five-year survivorship rate was a shocking 74.1 percent -- over the period, more than a quarter of the funds did so poorly that they ended up in the mutual fund graveyard. In other words, roughly 5 percent of actively managed disappeared every year.

Fourth, actively managed funds exhibited a great deal of style inconsistency -- just over 50 percent maintained consistency over the five-year period. Even 11 percent of real estate funds failed to maintain consistency. Among the other domestic asset classes, the lowest rate of style consistency was for mid-cap value funds at 32.1 percent, and the highest rate was for small-cap growth funds at just 61.2 percent. In other words, investors couldn't count on actively managed funds to provide them with consistent exposure to the asset classes in which they wanted to be invested.

Fifth, with one exception, the international data were very similar. Among actively managed global funds, 66.2 percent underperformed over the five-year period. For international funds, 71 percent underperformed. And, the worst performance came in the supposedly least-efficient asset class of emerging markets, with 80 percent of actively managed funds underperforming.

The sole exception was international small stocks where 55 percent of actively managed funds outperformed. The five-year survivorship rates for actively managed funds were 67.5 percent for global funds, 73.3 percent for international funds, 78.3 percent for international small funds, and a surprising (in light of their performance) 81.4 percent for emerging market funds.

It's important to note that all of the above figures are based on pretax returns. Given that the higher turnover of actively managed funds generally makes them less tax efficient, on an after-tax basis the failure rates would likely be much higher (since taxes are the highest expense for actively managed funds).