Vanguard founder John Bogle’s “cost matters hypothesis” explains why, after subtracting fees, returns from active management tend to be smaller than returns from passive management, as the latter costs less. However, retail investors tend to pay higher advisory and management fees than institutional investors.
Since 2002, S&P Dow Jones Indices has been publishing its S&P Indices Versus Active (SPIVA) U.S. Scorecard. The scorecard measures the performance of actively managed equity funds investing in domestic and international stocks, as well as active fixed-income funds, against their respective benchmarks.
SPIVA Weighs In
For the first time, the 2016 SPIVA Institutional Scorecard examined the impact of fees on the performance of mutual funds and institutional managed accounts against their appropriate benchmarks. The report, which analyzes actively managed funds across equity and fixed-income categories using gross- and net-of-fees returns, covered the 10-year period ending in 2016.
Following is a summary of its key findings:
- While institutional funds produced better results than mutual funds did, across all asset classes within the domestic equity space, the overwhelming majority of active managers—both retail and institutional—lagged their respective benchmarks. On a net-of-fee basis, the percentage of institutional funds underperforming their benchmark ranged from 63% (large value) to 96% (small growth). The degree of underperformance among small growth funds creates a problem for those who claim the market in small stocks is inefficient and thus ripe for active managers. For mutual funds, the percentage of active funds that underperformed ranged from 64% (large value) to 98% (midcap and small growth).
- 81% of actively managed international institutional funds failed to provide value after accounting for fees. And 84% of active mutual funds failed to do so. Performance was somewhat better in international small stocks, where “only” about two-thirds of institutional and mutual fund managers underperformed.
- 79% of active institutional managers investing in emerging market equities, which traditionally has been thought to be one area where active management can add value, fell short of the benchmark after fees. Mutual funds fared even worse, with 86% underperforming.
- The results in bond markets were not encouraging. In the 13 bond categories examined, the percentage of mutual funds that underperformed ranged from 59% (investment-grade bonds) to as high as 97% (high-yield bonds). The results were similar for institutional managers, though in one category a small majority of active funds outperformed. That occurred in investment-grade bonds, where only 48% of active institutional funds underperformed. This could be explained by active funds having taken more credit or duration risk than the benchmark. On the other hand, 100% of high-yield institutional managers underperformed, and in the supposedly inefficient asset class of emerging market bonds, 75% underperformed.
The findings from the SPIVA scorecard are consistent with those of Joseph Gerakos, Juhani Linnainmaa and Adair Morse in their December 2016 study, “Asset Managers: Institutional Performance and Smart Betas.” They studied the performance of delegated institutional asset managers with $18 trillion in annual average assets under management over the period 2000 through 2012—close to 30% of worldwide investable assets.
They found that on a risk-adjusted basis (accounting for exposure to common factors), the net excess return of institutional managers in U.S. equities was -1.16% with a t-stat of 2.60. For global equities, institutional managers’ net excess return was -1.69% with a t-stat of 2.29. However, the authors also found that the net alphas were positive for U.S. fixed income (0.17%) and global fixed income (0.58%), although statistically insignificant at even the 10% level in both cases (with t-stats of 0.45 and 0.91, respectively).
Even with the advantage of asset management consultants (the majority of institutional investors engage consultants such as Russell, SEI and Goldman Sachs) and the added benefit of incurring lower fees than retail investors, institutional investors failed to outperform appropriate risk-adjusted benchmarks. Additionally, the implementation costs of passive strategies such as index funds, ETFs and types of structured portfolios, continue to fall, creating even greater hurdles for active management.
As Yogi Berra would say, reading the annual SPIVA scorecards is like deja vu all over again. They also explain why the trend toward passive investing and away from active investing is so strong. There is one thing stronger than all the marketing machines of Wall Street and, to paraphrase author Victor Hugo, that is an idea whose time has come. The bottom line is that whether you’re an institutional or a retail investor, active management is the loser’s game.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.