Passive vs. Active

The “debate” rages on within the financial services industry – does active management add value? (If you are unclear about what “active” or “passive” management means, please read this first.) In reality, the debate is generally between academics and other professionals who have actually studied the data, and those who stake their livelihood upon the story of active management.

First, let’s look at the data. One of the very first studies on fund manager performance was conducted by Michael Jensen in 1965, and even this early study indicated that active managers underperformed broad market benchmarks. A wonderful ongoing example of this data is Standard & Poors(R) Indicies Versus Active Funds Scorecard or SPIVA. Using data free of survivorship bias this semi-annual report shows investors and advisors the percentage of actively managed funds that have been outperformed by their respective benchmarks over a one, three and five year period. This telling report regularly shows us that over half of actively managed funds in basically every category are outperformed by their benchmark. What this report doesn’t demonstrate, however, is that the less-than-50% of funds that managed to outperform the benchmark in the current time period are not likely to be the same ones that outperform in the next.

Let’s not forget that without making generous assumptions, it is nearly impossible to calculate true after-tax returns for actively managed funds compared with index funds. It has been quite difficult to arrive at the average holding period for mutual funds, but we can speculate with the help of cash flows that it is between three and five years. This frequent turnover of fund investors AND the regular distribution of capital gains from the funds themselves leads to regular capital gain taxes, leaving less after-tax money to be reinvested in a new actively managed fund, further reducing the active investor’s chances at “beating the market.”

Next, consider this. In a 2010 study, Morningstar research associates found that the most reliable predictor of future performance was not past performance, not Morningstar’s own star rating system, but mutual fund expenses. Dividing the existing fund universe into quintiles based on expense ratios, Morningstar found that returns correlated very closely along each quintle, with the highest returns coming from the lowest cost funds. This was true in every asset class and over every tested time period.

Finally, logic is our best line of reasoning. To borrow from John Bogle, William Sharpe, Burton Malkiel and many others, let me paint you a picture. First, we’ll recognize that a stock index is simply the collection of all available publicly traded stocks. And those stocks must be owned by individuals or managers. Therefore, the return of all of the individuals before any expenses or taxes must equal the return of the stock index, since they are the same universe. It must reason, then, that after expenses and taxes, the collective returns of the active managers are lower than the returns of the index by exactly the amount of the expenses and taxes. Even “the best” active managers must first overcome the hurdles of transaction costs, management fees, loads and taxes to deliver above-market results.

Despite these data and simple, rational arguments, certain active managers stand out in the crowd. However, they are no more than would be expected from any random distributions of returns. In fact, they are fewer (due to expenses)! A “star” manager’s apparent winning streak has empirically more to do with chance than skill. Eventually, these titans of asset management fall.