Winning At Active Management? Don’t Be Delusional

As long-term investors, we all want to reach our goals as reliably as possible. That means earning the returns necessary to accomplish what’s important to us, while enduring as little short-term pain as possible to get there.

Why, then, does so much money still support traditional “active” portfolio management – trying to pick outperforming individual stocks and bonds or hiring a professional to do it for us? Sure, some investors and some managers, some of the time, are able to accomplish this feat. But the odds of success are so low, no matter how we slice it, it seems almost delusional that you would invest in something other than an index or asset-class fund portfolio.

My guess is, beyond the “hope springs eternal” crowd, or the group that isolates one successful effort (amongst many additional failing attempts) as proof of their abilities, most people just don’t know how bad the odds of success are when traveling the active-management road. Well, for the 5,000 to 10,000 people who will probably read this article, let’s change that reality.

We’ll focus on the professionals here, (mostly) my fellow CFA charter holders who devote their careers to managing stock and bond portfolios designed to beat the market. Importantly, we have a bevy of long-term, verifiable evidence amongst this group which allows us to dissect the approach. Individuals managing their own assets, for sure, don’t have the expense ratio hurdle that the pros do, but this is a small consolation considering their significant disadvantage in experience, training and behavioral make-up.

So what does the evidence say? We’ll start with US stock funds over various periods ending in 2015.

STOCK FUNDS	5 Years	10 Years	15 Years
% That Disappeared	24%	41%	57%
% That Outperformed	29%	21%	17%

What we find is, over even relatively short periods of time (5 years), the vast majority of active managers fail to outperform their index. As a matter of fact, you have the same odds of outperforming as you do of choosing a manager who does so poorly their fund is closed down (“disappeared”). And the odds only get worse as the time frame is extended. At 15 years, almost 60% of managers disappear, and less than 20% outperform. There’s no way to sugarcoat this – those are terrible odds.

What about bonds over the same period?

BOND FUNDS	5 Years	10 Years	15 Years
% That Disappeared	20%	40%	57%
% That Outperformed	18%	12%	7%

If you can believe it, stock managers actually performed relatively well compared to their bond manager counterparts. The same approximate number of managers survived each period, yet the level of outperformance tanked, culminating with a 7% success rate at 15 years. When a low-cost bond index is available for just about every investor, it’s hard to figure out why anyone is crowding into the space (active bond management) where over 90% of professionals come up short.

Unfortunately, these statistics, which for the open-minded investor should probably be sufficient, are often lauded as irrelevant for serious students of the active management discipline, who usually fall into two different camps.

The first group points out that some managers do, in fact, outperform. Their logic from this observation is that they will select the relatively few managers who do outperform, not the “average” manager. This “Lake Wobegon mindset” exists amongst investors who believe they are endowed with above-average ability where so many other individuals and professionals have come up short. Where do they look? At past performance. Certainly, if a manager has built a previous track record of outperformance, the odds are high they’ll continue, right?

Asset Class	% Outperformers From 2001 to 2010	Subsequent Winners From 2011 to 2015
Stock Managers	20%	37%
Bond Managers	7%	51%

The chart above reports the percentage of stock and bond managers who outperformed their index during the initial 10-year period (2001 to 2010) and who also continued to outperform over the subsequent 5 years. This basically measures the odds that you’ll find an outperforming manager by sorting amongst historical track records. The findings are disappointing.

A little more than 1/3 of stock managers who outperformed their index in the first period continued to do so. Over 60% went on to underperform. With bond managers, the results are a little better – about 1/2 of outperforming managers who outperformed were able to keep up the pace. But even here, your odds of success are no better than a coin flip.

What this says in practical terms is that, yes, some managers outperform their index some of the time. While the amount is exceedingly low, it’s not zero. Unfortunately, there is precious little information about future outperformance contained in past results. Sorting on previously successful managers is more likely than not to produce future losers.

How about the low-cost crowd? Vanguard’s John Bogle started a movement with his cost-matters mantra. What used to be a sensible warning to watch your investment costs has become an excuse to invest in anything you want, as long as the expense ratios are low enough. Somewhere along the way, active management was given a second life, so long as the stock and bond pickers were generous enough to keep a lid on expense ratios.

There’s actually some credibility to this, if we set the bar low enough. What I mean is, low-cost active funds outperform their higher-cost counterparts. But they don’t routinely outperform the lowest-cost investments: passively-managed index and asset class funds.

Asset Class	% of Highest Cost Funds That Outperform	% of Lowest Cost Funds That Outperform
Stock Funds	7%	26%
Bond Funds	1%	10%

The table above looks at the 15-year period ending 2015, and breaks actively managed stock and bond mutual funds into the highest- and lowest-cost quartiles. One conclusion is that you have to be completely insane to buy an actively managed fund with high expenses (which averaged 2.05% and 1.24% for the stock and bond funds, respectively). In the bond category in particular, the odds of a manager overcoming a 1% or more fee looks to be nearly impossible.

But look at the lowest-cost category. These active-manager fee levels are pretty low, 0.83% and 0.42%, respectively. And yet only 26% and 10% of the low-cost quartile are able to outperform their index.

I’ll throw this in too, a few investors will counter that expense ratios don’t tell the whole cost story, that portfolio turnover is another good barometer of expenses (due to market impact, spreads, commissions, etc.). Indeed, if we perform the same sort of analysis as we did with expense ratios, ranking stock fund turnover by quartile, we see that 8% of high-turnover managers (215%) beat their index, and 29% of the lowest-turnover managers (28%) beat their index. So much for high-frequency traders sporting an unfair advantage! The low turnover group didn’t produce any better outperformance figures than the low expense ratio group, about one in four.

What can we take from this data?

• First, the markets seem fair for the average investor. There’s no evidence of rigging going on, we don’t have a situation where a handful of really smart, experienced investors are producing excess returns at the expense of the rest of us. Said more simply, there’s no such thing as “smart money.” You take risk and you get an expected return. No wizard behind the curtain can change that dynamic for you.
• Second, there are no golden tickets in active management. Past performance, expense ratios, turnover – no reasonable metric increases our odds of finding the proverbial needle in the haystack. Especially when we consider taxes (almost always higher for active managers), which this article mercifully excluded.
• Finally, your role as an investor, or what your advisor should be doing for you, is to focus on a goals-based asset allocation first, low-cost and broadly diversified fund implementation second, and disciplined management third. Sure, low-cost/low-turnover active management outperforms the high-cost/high-turnover approach, but there’s no cheaper, lower-turnover way to invest than index and asset class portfolios. Why settle for “good enough” when you can have the best?

I’ll add just one more consideration. For years, one of the casual knocks on index and asset class fund investing has been this belief that it creates “average” results. Whether you agree with my conclusions or you are a stubborn hold out, I think we can all agree that an approach which outperforms 80% or 90% of its counterparts simply cannot be called “average.”

True, index and asset class-investors will never be able to lay claim to the absolute best performance, but when “really good” is probably all that’s needed, and it is freely available to any investor, you have to ask yourself what the point of any more is? Especially considering how unlikely it is.

Source of data: Dimensional Mutual Fund Landscape, 2015

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Stock Plaza). I have no business relationship with any company whose stock is mentioned in this article.