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Expert Analysis and Commentary
Larry Swedroe Nov 17, 2016
For example, the excuse “making the rounds” after active mutual fund managers’ poor performance in 2015 was that their results were due to the market being very “narrow,” driven mainly by the “FANG” stocks (Facebook, Amazon, Netflix and Google). Of course, that excuse held as much water as the proverbial sieve, as the market was no more narrow than in most other years. In other years, the excuse has been that correlations among returns rose, presenting active managers with few opportunities to add value by distinguishing themselves. And then, when in the following year correlations fall and active mutual fund managers again fail, yet another excuse is created.
A great example comes from Morgan Stanley’s Adam Parker, who appeared in a June 2015 Bloomberg article. According to the article, one of the main reasons it’s so tough to beat the S&P 500 is that when the index “removes a company and adds another, the new stock tends to be an outperformer.” The article then quotes the note from Parker and his team: “The median stock removed from the S&P 500 has negative earnings growth in the preceding three and five year periods. The earnings growth of the companies added to the index was not only much superior to the companies removed but also much higher than those companies already in the index.”
Parker’s note went on to assert that this “causes a substantial, structural upward bias to the earnings growth of the S&P 500 index.” So Parker “decided to compare the earnings growth of companies in the S&P 500 that were in the index the previous year, each year — the so-called ‘apples to apples’ growth rate — to just the index level growth rate.” Showing “the difference in the year-on-year earnings growth rate of the S&P 500 using all stocks in the index vs the growth rate of the index excluding the new entrants,” he found “the median annual gap is 1.2%, and the index has beaten the ‘apples to apples’ companies for 8 straight years.”
But why were the added stocks outperformers? Parker and his team gave the following reasoning: “Why is there an almost permanent gap in earnings growth between the overall index and apples to apples companies? Because the new companies that are added to the index typically have much higher margins than both the companies removed and the surviving constituents … with faster prior revenue and earnings growth, and higher margins, the stocks added to the index typically have performed much better over the few years before their inclusion.”
The Bloomberg article concluded that “Morgan Stanley’s advice to active managers is to avoid companies in the S&P 500 that have ‘poor [earnings per share] growth, very low margins and negative price momentum.’”
With that critique in mind, which in effect blames the failure of active managers on the fact that the S&P 500 is itself not a fair benchmark because it is actively managed, I thought I would show why this excuse doesn’t measure up.
While we could debate whether or not the S&P 500 is actively managed, I, personally, agree that it is. For me to consider it passive, the index would have to be either the top 500 stocks by market capitalization or, if not, the screens used would have to be rules-based with no reliance on the subjective judgments of committee members. That leaves the question of whether or not the S&P 500 is a fair benchmark.
To examine if the “charge” of an incorrect benchmark has any validity, we can compare the returns of the S&P 500 Index to completely unmanaged indices. We’ll begin with the Russell 1000 Index, which is an index of the 1,000 largest companies that started in 1979. Through July 2016, the unmanaged Russell 1000 returned 11.77%, slightly outperforming the 11.73% return of the “managed” S&P 500 Index. Another good benchmark for the S&P 500 is the CRSP Index of large-cap stocks (deciles 1-5 of all stocks ranked by market cap as determined by NYSE stocks). Over this same period, the unmanaged CRSP 1-5 Index provided exactly the same return as the S&P 500 Index, 11.73%. And, since the S&P 500 Index began life in 1957 through July 2016, it returned 10.00%, virtually identical to the 10.01 percent return of the unmanaged CRSP 1-5 Index.
On a more amusing note, Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, provided us with further evidence supporting our conclusion. In his 2005 book, “The Future for Investors,” he presented the results of his study on the S&P 500 Index. He found that the original 500 firms in the S&P 500 (425 industrials, 25 railroads and 50 utilities) actually outperformed the conventional S&P 500 Index over the period from March 1, 1957 (inception of the 500-firm index) through Dec. 31, 2003. He computed the original S&P 500 return in three ways to account for the behavior of spinoffs and mergers in various forms: Survivors, Direct Descendants and Total Descendants. He got an annualized return of 11.31%, 11.35% and 11.40%, respectively, compared to 10.85% for the S&P 500 Index with its periodic reconstitution (917 firms in total).
Continually replenishing the index with the new, faster-growing firms that Morgan Stanley’s Parker argued created a higher hurdle for active managers, while removing the older, slower-growing firms, actually lowered the returns to investors. In other words, the committee’s efforts made it easier, not harder, to outperform the index as Parker claimed because they were counterproductive. Investors would have been better off had they bought the original S&P 500 firms in 1957 and never made any changes to their portfolio.
My recent book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, presents evidence demonstrating that over the past 20 years there has been a persistently declining percentage of active managers generating statistically significant alpha, from about 20 percent to about 2 percent today. And that’s even before considering the impact of taxes. Thus, be prepared for more lame excuses from active mutual fund managers next year, and the year after, and so on.
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