Active investing: the triumph of hope over experience

Latest SPIVA Scorecard confirms indexing approach

Standard & Poor has, for the first time, released a mid-year “Indices versus active funds” (SPIVA) scorecard [1]. It compares the performance of actively managed mutual funds against relevant benchmark indices, covering U.S. equity, international equity and fixed income categories.

The fund returns used are net of fees, but exclude loads (eg broker commissions or platform fees). It adjusts for survivorship bias (poorly performing fund eventually close, giving a positive performance bias to remaining funds), measures returns against size and style-relevant benchmarks and calculates both equal- and asset-weighted peer averages.

The report concludes that “the latest five-year data for domestic equity funds can be interpreted favorably by proponents of passive management. Indices have outperformed a majority of active managers in nearly all major domestic and international equity categories. In addition, five-year asset-weighted averages suggest that active managers have fallen behind benchmarks in 11 out of 18 domestic fund categories.”

This is not just a US phenomenon. According to the Australian version of the report [2], more than 60% of all active funds underperformed their benchmark over the last five years. The number was 70% for Australian general equity funds and 69% for international equity funds.

Similarly, in India [3], “the majority of large cap funds and diversified equity funds underperformed their benchmark indices over 1, 3 and 5 years.”

Not all fund types lagged their indices. Particularly among small caps active managers have a good record against benchmark indices. But for well-researched sectors it becomes harder to beat the market consistently. This is particularly true for the large cap equities and fixed income categories, where most pension money is invested.

The numbers are even worse in South Africa. Over the five years to December 2010, a mere 14% of domestic general equity unit trusts beat the FTSE/JSE All Share Index [4].

Active management: vanity fare

There is a great irony in these results, because it is the primary goal of active managers to deliver an above-average outcome. They attempt this by holding (or selling) securities and asset classes that appear mispriced, in order to profit once the broader market recognises and corrects this mispricing.

But it is an endeavour rooted in vanity rather than reason: to justify their occupation, every active manager must believe they are smarter than all their competitors put together. Why? Because together, they are the market. Is their combined thinking and value estimates that set the price of all assets and thus the entire market. And if the goal is to beat the market (or benchmark), then their skill and insight must, by implication, exceed the collective skill of all the other investors put together.

This is possible in markets that are poorly researched, or leak information. But with modern media and information technology, they are becoming rare. All major developed and emerging markets now feed on a steady flow of news, company announcements, management updates, economic releases, financial TV, analyst reports and market commentaries.

The data is analysed by industry experts, academics, accountants, economists, statisticians, mathematicians, engineers, geologists, traders…a long list of talented people who look at published information from vastly diverse perspectives. Be it technical or financial analysis, bottom-up or top-down, practically no angle on the market is left uncovered.

And the competition is intense. General equity funds compete with hedge funds, small cap funds, value funds, growth funds, dividend funds, country funds and industry funds – a host of specialised investment managers scouring the market for style-particular opportunities. And beyond the human element, there is a mass of code, spreadsheets, trading strategies and analytical tools dissecting published economic and company data, identifying trends, correlations, deviations, flagging abnormalities and exceptions, driving quantitative investors, program traders and index arbitrators to squeeze the last few cents of inefficiency out of the market.

Market prices are quoted widely and promptly and react swiftly to news and developments. All insight quickly finds its way into the price of every security, and thus the entire market. Regulations, closed periods and embargos, all monitored by compliance and surveillance departments, ensures that price-sensitive information is released fairly and evenly to the market.

Of course, even these conditions do not produce a perfectly efficient market. Not all relevant information immediately finds the market; there are opportunities for those willing to invest time and energy to unearth uncommon insights, and trade ahead of the pack. However, time and energy are limited and costly resources that have to be allocated. This prevents anyone discovering all opportunities, and to outperform the market consistently.

The more relevant question is thus whether investors can consistently exploit market inefficiencies. Based on the reported results, the answer is clearly “no”.

Yes, there are a small number of exceptional fund managers who do outperform over the long-term, through a combination of skill and luck. But the exceptions merely prove the rule. The likes of Warren Buffett, Anthony Bolton, Peter Lynch and Bill Miller would not stand out, were their outperformance was not so extra-ordinary. Unfortunately, it is impossible to identify these positive outliers ahead of time. It is a gamble, and it does not pay to gamble with pension money.

If you can’t beat them…

Yes, active managers play an important role in financial markets, assisting in price discovery and the efficient allocation of capital. But it is also an expensive role, paid for by the investor. Every year, literally billions of rand in fees fall into the hands of the active investment industry promising a “better outcome”.

The impact of fees on the investor return is dramatic as it compounds: over the course of a 40 year contribution period, every one percentage point in fees saved improves the real (after-inflation) value of the retirement asset by approximately 30%.

So what is the answer? It is quite simple, really: if you cannot beat the benchmark, then join it. This is possible with an investment strategy called indexing.

Index funds simply replicate the benchmark and thereby capture the benchmark return at very low cost. Investors avoid regular trading, market research and fund management charges, and the resultant lower fees ensure an above-average outcome. As a group, these investors always earn a higher return than the average active investor.

Contrary to industry claims, investors have no moral obligation to assist in price discovery. There is more than enough money in the hands of hedge funds, wealth managers, speculators and traders to keep the market efficient. It is not necessary for retirement investors to commit their pension money as well.

No, investors should behave rationally, as financial theory dictates. And what could be more rational than to forgo active management risk, and to reap the market return at the lowest possible cost?