The evidence is overwhelming that most actively managed funds underperform their appropriate benchmarks, especially after taxes.
However, not all actively managed funds underperform, just a large majority of them. Those who believe in active management as the winning strategy believe they can identify the small minority of actively managed funds that will outperform. The only-somewhat logical way to choose these funds is to rely on past performance as a predictor of future returns.
One test of whether or not past performance is predictive of future performance is to see if more actively managed funds outperform than would be randomly expected. If fewer funds do so, it’s hard to know if any outperformance was simply a result of random luck—just as someone might flip 10 heads in a row—or skill. Because there are enough actively managed funds in the market playing the game, at least some should be randomly expected to outperform their benchmark 10 years in a row.
Twice each year Standard & Poor’s produces its persistence scorecard. And twice each year, it’s déjà vu all over again. The evidence is virtually identical, with fewer active managers showing persistent outperformance than would be randomly expected. The following is a summary of S&P’s June 2014 report:
- For the three years ended March 2014, 14.1 percent of large-cap funds, 16.3 percent of midcap funds and 25 percent of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. Random expectations would suggest a rate of 25 percent.
- Only 3.1 percent of large-cap funds, 3.6 percent of midcap funds and 5.5 percent of small-cap funds maintained top-half performance over five consecutive 12-month periods. And not a single large-cap or midcap fund managed to remain in the top quartile at the end of the five-year measurement period. Random expectations would suggest a repeat rate of 6.25 percent.
- The odds of a top-performing fund becoming a bottom-performing one were the same as the odds that a bottom-performing fund would become a top performer. Of 426 funds in the bottom quartile, 28.6 percent moved to the top quartile over the five-year horizon, and 28.6 percent of those top-quartile funds moved into the bottom quartile during the same period.
Broadly, the results clearly show there is no persistence of performance beyond the randomly expected. The only persistence here is the persistence of the evidence that past performance isn’t prologue when it comes to actively managed funds.
Worse yet, you have to keep in mind that all of the data are for pretax returns. On an after-tax basis, the results would be much worse because taxes are frequently the greatest expense for actively managed funds held in taxable accounts.
The continuing evidence from the Standard & Poor’s scorecards demonstrates one reason Charles Ellis, author of the classic investment book, now in its 6th edition, “Winning the Loser’s Game,” labeled active management a loser’s game. While it’s a game that’s possible to win, the odds of doing so are so low that it’s not prudent to try.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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