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Let’s look at some of the evidence S&P presented in its webinar, beginning with the performances of actively managed funds. For the 10-year period ending in 2014, S&P found that after fees, the majority of actively managed funds in all major categories underperformed their respective benchmarks. For those familiar with the evidence, this shouldn’t come as any surprise. However, what may be surprising is that with the sole exception of the asset class of large value stocks, this held true even when considering gross, rather than net, returns. In other words, active funds underperformed even after their expense ratios were added back. Even in the asset class of large-cap value stocks, only a slim majority (53%) of actively managed funds beat their benchmarks, while just 41% did so – net of fees.
This serves as pretty strong evidence that the markets are highly efficient in setting prices. It also shows the importance of considering the total costs of active management. With that in mind, let’s look at the total costs of active management.
Other costs include trading costs – bid-offer spreads, market impact costs and commissions – as well as what is referred to as the “cost of cash.” While index funds always are fully invested, actively managed funds typically hold some percentage of their assets in cash, either because they are attempting to time the market or because they are waiting to find a good stock to buy.
Wermers found that on average, the cost of cash for actively managed funds was 0.7%. And total trading costs easily can exceed 1%, especially for small-cap funds and emerging market funds. Plus, for taxable investors, the higher turnover of actively managed funds would add still another heavy burden to overcome.
Over the 10 years ending December 31, 2014, less than 14% of actively managed small-cap funds – in growth, core or value – beat their respective benchmarks, and just 7% of actively managed high-yield funds did so. With stocks, this is looking only at pretax returns. Given that taxes often are the greatest expense for actively managed funds, even this dismal figure overstates their performances for taxable investors.
The S&P researchers analyzed the performances of actively managed domestic equity funds ranked in the top quartile for two consecutive five-year periods. They found that at best, only 1% of multi-cap funds in the top quartile for the first five-year period managed to remain there for the second five-year period, which ended March 2015. And not a single one of the funds in the other categories – small-cap, mid-cap and large-cap – beat their benchmarks the second time around. The proverbial monkey throwing darts would be expected to do better than that.
The impact of these trends can be summarized in the following data. Twenty years ago, about 20% of actively managed funds generated statistically significant alphas. Today, that figure is down to about 2%. And that’s before considering the impact of taxes.
The conclusion I hope you’ll draw is that just as it’s OK to set up a small entertainment account for a visit to the racetrack or the casino, you wouldn’t take your retirement account to either of those places – because doing so is playing a loser’s game. The same is true of the game of active management. If you want to learn more about this subject, pick up a copy of “The Incredible Shrinking Alpha.”
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