One of the most hotly debated questions among investors today is whether an active strategy (using technical and/or fundamental analysis) or a passive strategy (employing no individual stock selection and/or market timing) is more likely to allow them to achieve their financial objectives.
While the debate is still ongoing, year after year we see results (such as those presented in Standard & Poor’s Indices Versus Active, or SPIVA, scorecard) showing that a large majority of active managers failed to beat their appropriate benchmarks, as well as a lack of persistence in outperformance beyond the randomly expected. And year after year, we hear excuses from active managers explaining why last year they failed to outperform and why next year will be different. Unfortunately, next year is never different. As a result, active managers constantly have to come up with new excuses.
One year the excuse is that correlations have fallen. The next year it’s that the dispersion of returns has narrowed. The year after that, it’s that the Federal Reserve is engaged in financial repression. There’s always an excuse.
With this in mind, I thought I would relate one of the more amusing excuses I’ve heard recently: It’s not fair to compare the performance of active managers to such indexes as the S&P 500 or the Dow Jones Industrial Average (DJIA) because, unlike an index from the CRSP (The Center for Research in Security Prices at the University of Chicago), their funds are actively managed, meaning the securities are selected by a committee.
This excuse is amusing on two fronts. First, as stated above, there’s an overwhelming body of evidence showing that the vast majority of actively managed funds persistently fail to outperform indexes such as the CRSP or the Fama-French indexes, that do not have a selection committee making individual decisions to include or not include a company in the index (they are instead constructed by ranking stocks by certain criteria, such as market capitalization or price-book ratios).
Second, despite Wall Street wanting and needing investors to believe that the active updating of firms within the S&P 500 and DJIA is essential to obtaining the high returns these indexes have recorded, as you’ll see, the evidence is that the active security selection engaged in by the committees at S&P Dow Jones Indexes have actually led to lower returns. In other words, these committees are no better at stock selection than are active managers. And they don’t even have implementation costs to overcome! We’ll begin by looking at the evidence on the security selection record of the S&P 500 committee.
Buy-and-Hold Always Wins
In their 2004 study, The Long-Term Returns on the Original S&P 500 Firms, Jeremy Siegel and Jeremy Schwartz calculated the return of all 500 of the original S&P 500 companies as well as of the new companies that have since been added to the index. They found that the buy-and-hold returns of the 500 original firms not only had outperformed the returns of the continually updated S&P 500 index, but that they did so with less risk.
The authors also found that new firms added to the S&P 500 Index since 1957 had underperformed the original firms in nine of 10 industrial sectors. They even highlighted a negative aspect of this form of indexing, one that creates a drag on returns. When a stock is selected for inclusion, there is price pressure exerted by indexers who must buy the stock.
Yet, despite the evidence regarding the negative impact of the choices made by the S&P 500 selection committee and the drag from price pressures associated with including new stocks, active managers persistently underperform the S&P 500 (as well as the other S&P indexes).
In his highly informative as well as entertaining book, “Standard Deviations: Flawed Assumptions, Tortured Data, and Other Ways to Lie with Statistics,” economics professor Gary Smith cited his own study, The Real Dogs of the Dow. With his co-authors, Anita Aurora and Lauren Capp, Smith examined the impact of the 50 additions and deletions to the DJIA’s 30 stocks that had occurred since October 1, 1928, when the DJIA began life.
The authors found that in 32 cases (64%), the deletions outperformed the additions. In 18 cases (36%), the additions outperformed the deletions. More importantly, a portfolio of deleted stocks beat a portfolio of added stocks by about 4% a year. In other words, the Dow deletions, companies doing so poorly that they were booted out of the index, have outperformed the darlings that replaced them.
In 1998, Charles Ellis’s book, “Winning the Loser’s Game” was published. He presented evidence demonstrating that while it was possible to outperform using active strategies, the odds of doing so are so poor that it’s imprudent to try. Thus, just as is the case with loser’s games like those played in the casinos of Las Vegas (e.g., blackjack, the slot machines, roulette), the winning strategy is to not play. By not playing, Ellis meant to use passively managed funds, such as index funds.
Unfortunately for investors using active strategies or mutual funds, the odds of winning have been persistently falling since Ellis’ book appeared. In our book, “The Incredible Shrinking Alpha,” my co-author, Andrew Berkin, and I present evidence demonstrating how much more difficult it has become. For example, 20 years ago the odds that a mutual fund would generate statistically significant alpha were about 20%. Today, that figure is about 2%. We also present the reasons why this trend has been so persistent, as well as explain why it is likely to continue to make life ever more difficult for those choosing active strategies while still lining the pockets of the active fund purveyors.
The Bottom Line
As sure as the sun will rise in the east, I am confident that active managers will keep coming up with excuses for their poor performance and hope that you’ll buy into them so they can continue to transfer wealth from your wallet to theirs.