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I was doing some research recently when I noticed that, according to Morningstar, the DFA International Small Cap Value Fund had a 1st percentile ranking for the latest 15-year period. Seeing that ranking reminded me of the many conversations I’ve had over the years with devotees of active portfolio strategies.
From those conversations, I’ve learned that even many of active management’s strongest advocates concede the efficiency of the market for U.S. large-cap stocks is so great that any attempt to add value (generate alpha) through active management in that space is highly unlikely to produce positive results. However, they will cling religiously to the idea that active management is the winning strategy in so-called inefficient markets, such as international small-cap stocks and emerging market equities.
Even before looking at some evidence, I find it pretty amazing that this myth about active management as the winning strategy in inefficient markets manages to persist after the 1991 publication of William Sharpe’s brilliant short paper, “The Arithmetic of Active Management.”
Using simple arithmetic, Sharpe demonstrated that active management, in aggregate, must be a loser’s game. In aggregate, active managers must underperform proper benchmarks. Sharpe’s mathematical proof shows that this holds true not only for the broad market, but also when the market is in a bull or bear phase. And it also must hold true for market sub-sectors, such as small stocks or emerging market stocks.
Sharpe concluded: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
But, given the persistence of this myth, I thought it worthwhile to provide some powerful evidence demonstrating how and why the claim is false. To start, Morningstar provides a percentile ranking for the mutual funds falling into each of its categories. If active management is a winner’s game in international small-cap stocks and emerging market stocks, we should expect to see funds from Dimensional Fund Advisors (DFA), which doesn’t engage in active management strategies such as individual stock selection or market timing, to have relatively low rankings. The 1st percentile is the top score and the 100th percentile is the worst. (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) The rankings used here are for the 15-year period ending March 2:
The average ranking for the five DFA funds in these supposedly informationally inefficient asset classes was just greater than 11. That means DFA funds outperformed an average 89 percent of actively managed funds in their respective categories. That doesn’t sound like active management is the winning strategy to me. Not when 88 percent of the surviving actively managed funds underperform a passive strategy. And what’s more, this score understates the reality because about 7 percent of all funds disappear each year, and the Morningstar rankings contain survivorship bias. If survivorship bias were accounted for, the rankings of the DFA funds would have been even better.
In October 2014, Vanguard’s research team took a look at the issue of active manager performance in inefficient markets. Their findings demonstrate the falsehood of these myth-tellers’ claims. Vanguard concluded that once they accounted for survivorship bias, 84 percent of small-cap U.S. funds, 73 percent of non-U.S. developed markets funds and 71 percent of emerging market funds underperformed the average return of low-cost index funds in those same categories over the 10 years ended 2013.
Now, it’s true that those figures are all better than the 85 percent of large-cap U.S. funds that underperformed their benchmark over the same period. But it doesn’t change the fact that active management clearly was a loser’s game anywhere you looked.
It’s also important to keep in mind that all of the data we’ve used here is based on pre-tax returns. And the greatest cost of active management in taxable accounts typically is taxes. So, if taxes were considered, the results would look even worse for active managers.
The evidence makes clear that the real question is not whether active managers are likely to win in less informationally efficient markets, but why the myth persists. That one is easy to answer. It’s because while active management remains a loser’s game even in informationally less efficient markets, it’s a winner’s game for the purveyors. In other words, it exists because it’s the triumph of hype and marketing over wisdom and experience.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 14 books, including his most recent, The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.
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