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One of my firm’s clients recently asked if I would read the book and provide my thoughts on it. Given Klarman’s reputation, I was surprised to come across the following from its introduction: “Hundreds of billions of dollars are invested in virtual or complete ignorance of underlying business fundamentals, often using indexing strategies designed to avoid significant underperformance at the cost of assured mediocrity.”
When it was formed, the fund was heavily derided by the mutual fund industry. It was even described as “un-American,” and inspired a widely circulated poster showing Uncle Sam calling on the world to “Help Stamp out Index Funds.” The fund was also lampooned as “Bogle’s Folly.”
Fidelity’s chairman, Edward Johnson, assured the world that Fidelity had no intention of following suit when he said: “I can’t believe that the great mass of investors are going to be satisfied with receiving just average returns. The name of the game is to be the best.” Ironically, today Fidelity is one of the market’s largest providers of index funds. At the time, another fund manager, National Securities and Research Corporation, categorically rejected the idea of settling for “average.” In a flier the firm stated: “Who wants to be operated on by an average surgeon.” And that refrain became one of the big lies that Wall Street tells: indexing (and passive investment in general) gets you average (or mediocre) returns. Yet, nothing could be further from the truth.
Before going through the mathematics, we can take a look at the actual evidence to see if indexing, and more generally passive investing, in “virtual or complete ignorance of underlying business fundamentals” has truly provided average or mediocre returns.
Vanguard is a leading provider of index funds. While DFA’s funds are passively managed, they’re not index funds. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
When reviewing the rankings, keep in mind that they contain survivorship bias. Funds that have done poorly often disappear, either because investors fled and the fund was closed or the fund family decided to merge a poorly performing fund into a better performing one. About 7% of funds close every year.
Because poorly performing funds tend to disappear from the rankings, the actual performance ranking of surviving funds is significantly understated. And the longer the period, the worse the survivorship bias becomes (due to more funds having gone to the mutual fund graveyard).
|Fund||10 Years||15 Years|
|(as of Sept. 18, 2015)||25||45|
|DFA U.S. Large (DFUSX)||22||42|
|Vanguard Value Index (VIVAX)||39||66|
|DFA U.S. Large Value III (DFUVX)||18||4|
|Vanguard Small Cap Index (NAESX)||12||51|
|DFA U.S. Small (DFSTX)||16||38|
|DFA U.S. Micro Cap (DFSCX)||41||57|
|Vanguard Small Cap Value Index (VISVX)||21||48|
|DFA U.S. Small Value (DFSVX)||41||23|
|Vanguard REIT Index (VGSIX)||34||32|
|DFA Real Estate (DFREX)||43||29|
|Vanguard Developed Markets Index (VTMGX)||41||41|
|DFA International Large (DFALX)||41||40|
|DFA International Value III (DFVIX)||23||9|
|DFA International Small (DFISX)||26||20|
|DFA International Small Value (DISVX)||11||1|
|Vanguard Emerging Markets Index (VEIEX)||47||42|
|DFA Emerging Markets II (DFEMX)||24||30|
|DFA Emerging Markets Value (DFEVX)||30||6|
|DFA Emerging Markets Small (DEMSX)||1||1|
|Average Vanguard Ranking||31||46|
|Average DFA Ranking||26||22|
It’s interesting as well that DFA’s highest rankings were in the very asset classes active management proponents say are the most inefficient: emerging-markets small-cap stocks and international small-cap stocks. Even with all the survivorship bias in the data, in both of these asset classes the DFA funds managed to post a first-percentile ranking.
It’s also important to note that the rankings are based on pre-tax returns. In most cases, index and other passively managed funds will be more tax efficient, due to their typically lower turnover. ETF versions can further enhance the tax efficiency of index funds.
Furthermore, each time Standard & Poor’s releases its twice yearly Indices Versus Active (SPIVA) performance scorecards, you see additional evidence regarding just how big a lie it is that indexing gets you average or mediocre returns.
Having presented the evidence, we’ll now turn to the irrefutable logic of the laws of mathematics.
Sharpe’s “proof” demonstrated that this holds true not only for the broad market, but also for when the market is in a bull or bear period as well as for market subsectors (for example, both small stocks and emerging-market stocks). The reason is simple: all stocks must be owned by someone.
Let’s further assume that the market returns 15% per year for the period in question. We know that on a pre-expense basis, a passive strategy (owning Vanguard’s total stock market fund, for instance) must earn 15%. What rate of return, before expenses, must active managers have earned? The answer must also be 15%.
The following equations show the math:
If one active investor outperforms because he overweighted the top-performing stocks, another active investor must have underperformed by underweighting those very same equities. The investors that outperformed had to buy those winning securities from someone. Since passive investors simply buy and hold, the stock must have been sold by another active investor. In aggregate, on a pre-expense basis, active investors earn the same market rate of return as passive investors.
Note that if we substituted the S&P 500 Index—or small-value stocks, real estate investment trusts (REITs) or emerging-market stocks—for the total stock market, we would come to an identical conclusion. It doesn’t matter which asset class we are discussing, the math is exactly the same.
The same thing is true for bull and bear markets. The math doesn’t change if the bull is rampaging or the bear comes out of hibernation. Active management must earn the same pre-expense gross return as passive management, regardless of asset class or market condition.
However, because active managers also bear the burden of greater costs incurred in the pursuit of outperformance (operating expenses, transactions costs, market impact costs, the drag of low returns on cash holdings and, for taxable accounts, taxes) their net returns—the only kind you get to spend—must, in aggregate, be lower.
While it’s possible to win the game of active management, the odds are so poor that it simply isn’t prudent to try. Which is why Charles Ellis called active management the loser’s game. Making matters worse, the evidence demonstrates clearly that active management is a game that has become increasingly difficult to win. In fact, the percentage of active managers generating alpha has fallen about 90% in relative terms (from about 20% to about 2%) over the past 20 years.
Wall Street needs you to believe in the myth that active management is the winning strategy because, while it’s the loser’s game for investors, it’s the winner’s game for them.
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