At the end of 2014, Tom Lee, co-founder and head of research at Fundstrat Global Advisors, explained why only about one out of five actively managed funds were able to outperform their benchmark index that year, and why he believed that 2015 could be huge for stock pickers. In fact, “2015 should be a very good year for active managers,” he predicted.
As sure as the sun rises in the east, you’re going to hear statements like Lee’s from active managers. They’re always predicting that next year will be different; that it will be one in which stockpickers will shine. And with almost the same certainty that the sun will set in the west, the results will show otherwise.
Last year provided yet another demonstration that active management is the loser’s game. It’s not that the game is impossible to win; it’s just that the odds of doing so are so poor that it’s not prudent to try.
The table below presents the Morningstar percentile rankings—a ranking of 1 represents the best performance, a ranking of 100 represents the worst performance—for two of the largest providers of passively managed funds, Vanguard (index funds) and Dimensional Fund Advisors (structured asset class funds) over the latest one-, three-, five-, 10- and 15-year periods. (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds in constructing client portfolios.)
Morningstar Percentile Ranking
|Vanguard 500 Index (VFINX)||23||20||16||23||37|
|DFA U.S. Large (DFUSX)||21||18||14||20||34|
|Vanguard Value Index (VIVAX)||17||10||15||32||61|
|DFA U.S. Large Value III (DFUVX)||44||7||7||22||3|
|Vanguard Small Cap Index (NAESX)||38||30||24||15||40|
|DFA U.S. Small (DFSTX)||31||22||19||14||22|
|DFA U.S. Micro Cap (DFSCX)||35||21||19||14||22|
|Vanguard Small Cap Value Index (VISVX)||38||7||6||21||56|
|DFA U.S. Small Value (DFSVX)||71||41||29||43||15|
|Vanguard REIT Index (VGSIX)||65||37||34||30||36|
|DFA Real Estate (DFREX)||42||26||22||40||34|
|Average Domestic Ranking||39||22||19||25||33|
|Vanguard Developed Markets (VTMGX)||37||29||28||33||40|
|DFA International Large (DFALX)||72||57||50||38||42|
|DFA International Value III (DFVIX)||77||59||77||26||6|
|DFA International Small (DFISX)||43||41||64||27||40|
|DFA International Small Value (DISVX)||44||26||31||10||1|
|Vanguard Emerging Markets Index (VEIEX)||62||54||56||52||48|
|DFA Emerging Markets II (DFEMX)||64||56||46||32||42|
|DFA Emerging Markets Value (DFEVX)||86||88||92||37||11|
|DFA Emerging Markets Small (DEMSX)||16||16||16||1||1|
|Average International Ranking||56||47||51||28||26|
|Average Vanguard Ranking||40||27||26||29||45|
|Average DFA Ranking||50||41||37||25||21|
As you review this data, there are three important issues to keep in mind. The first is known as the “law of style purity,” sometimes referred to as Dunn’s Law (after the Southern California attorney who provided the insights).
Dunn’s Law states that when an asset class does well, index funds will tend to perform relatively better because they have the “purest” (greatest) exposure to the stocks in that asset class. Active managers, however, tend to style-drift. For example, large-cap funds often own mid- and small-cap stocks, small-cap funds often own mid- and large-caps, and growth funds often own value stocks. Thus, active managers tend to lose some of their exposure to both the “winning” and “losing” asset classes.
On the other hand, when an asset class does poorly, index funds will tend to perform relatively worse because they have the “purest” (greatest) exposure to the stocks in that asset class, and the style drifting of actively managed funds gives them less exposure.
In 2015, the best-performing domestic asset class was large-cap stocks, and the worst-performing domestic asset class was small value stocks. Thus, the relatively strongest rankings for the Vanguard and DFA funds are in U.S. large stocks and their worst rankings come in U.S. small value stocks. The relatively poor performance of international equities also helps explain the worse percentile rankings for the Vanguard and DFA funds in those asset classes in 2015, and for the recent one-, three- and five-year periods.
Another point to keep in mind is that the DFA funds tend to have more exposure to the small and value factors than the similar Vanguard funds. Thus, when those asset classes have relatively poor returns, the Vanguard funds will tend to outperform the DFA funds, and vice versa.
A Law In Action
The following is evidence demonstrating the explanatory power of Dunn’s Law. In every year from 1995 through 1998, the S&P 500 Index managed to outperform the MSCI U.S. midcap and small-cap indexes, generally by wide margins.
In each of those years, the S&P 500 Index outperformed about 80% or more of active managers (about 94% for the entire period, even before taxes). On the other hand, during periods like 1977 through 1982, when small-caps outperformed large-caps by about 16% per annum, only in a single year did index funds outperform even 40% of active large-cap managers.
The reason is simple. Active large-cap managers tend to own smaller-cap stocks than those in the S&P 500 Index. In other words, they style-drift. They held some of the “outperformers,” unlike in 2015, when they held some of the “underperformers.”
In periods when the S&P 500 outperforms, you hear claims from active managers like, “It wasn’t a stock picker’s year.” Stock picking, as we’ve shown, has virtually nothing to do with it. It’s all about asset allocation. Active managers appear to lose (or win) because they style-drift.
In periods when small-caps outperform the S&P 500, active managers claim victory for their stock-picking skills. Again, stock picking likely had little or nothing to do with it. If it did, then the same managers would keep repeating their outperformance, but we see very little evidence of that occurring.
The second issue we need to address is the existence of survivorship bias in the data.
About 7% of actively managed funds disappear each year (due to poor performance). But unfortunately, Morningstar’s data doesn’t account for this survivorship bias, and the longer the period, the worse the bias becomes.
Thus, if survivorship bias were accounted for, the relative performance of the Vanguard and DFA funds would be higher. As one example, if survivorship bias were taken into account, it is highly likely that the 15-year average ranking for Vanguard’s funds would be better than the 45th percentile.
As for the 13 passively managed DFA funds in the preceding table, the average 10-year and 15-year rankings were 25% and 21%, respectively, meaning they outperformed 75% and 79% of surviving funds. Again, if the Morningstar data accounted for survivorship bias, their rankings would be considerably better.
It is also interesting to observe that the funds’ highest rankings were in the very asset classes proponents of active management say are the most inefficient—international small and emerging markets small equities.
In fact, both DFA’s international small-cap fund (DFSIX) and its emerging markets small-cap fund (DFSIX) achieved a first-percentile ranking over the most recent 15-year period. It’s hard to make the claim that these markets are inefficient when funds that don’t engage in any market timing or individual security selection outperform virtually all active funds.
Yet you can be sure you’ll continue to hear claims by proponents of active management that these are inefficient asset classes. However, the concept that active management wins in less informationally efficient markets is simply another myth that the mutual fund industry works hard to perpetuate.
A third issue to note is that the Morningstar rankings are based on pretax returns. In most cases, index and other passively managed funds will be more tax efficient, due to their typically lower turnover. And ETF versions would only further enhance the tax efficiency of index funds.
Einstein said that there were only two things that are infinite: the universe and human stupidity. I would add a third: the ability of active managers to come up with excuses that attempt to explain their persistently poor performance.
Of course, you don’t have to play the loser’s game. As the evidence presented in the table demonstrates, over the long term, if you simply accept market returns in the asset class to which you want exposure, you’re virtually assured to outperform the vast majority of active investors, both individual and institutional. And that’s the closest thing to a guarantee you’ll get in investing.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.