As readers of my books and articles know, I don’t participate in the game of making predictions. Whenever I am asked for a forecast about the economy or the markets, my standard response is that, while I might have my own personal views, I’ve learned there are no clear crystal balls.
In fact, the academic research on the subject has concluded that there are no good forecasters. That knowledge is why I don’t make investment decisions based on my personal views. I’ve no reason to believe I’m likely to succeed where others have failed.
However, I make one exception to this rule. There’s one forecast I know I can make with the same certainty I have about the sun rising in the east. I know—for certain—that, at the end of each year, active managers will come up with an excuse for their failure to outperform index funds.
They’ll also predict that next year will be different: It’ll be a “stock-picker’s year.” I have yet to be disappointed with this forecast, with the following being a good example of why.
The End Of Macro?
I was recently stuck at home dealing with a bout of the flu. With some time on my hands, I decided to dig into my collection of what I refer to as “investment porn” (to borrow a term from author Jane Bryant Quinn). I found a December 2012 article headlined “The Era of 'Macro' May Finally Be Coming to An End.”
The author quoted Bank of America’s Chief Investment Strategist: “The pair-wise correlations of all S&P 500 stock combinations has fallen to 30%, down from a high of 70% in 2011. This indicates that we are close to being in a differentiated/stock picker’s market.”
A chart was then presented showing the historical evidence on the correlations of all possible pairs of the stocks within the S&P 500 Index from 1986 through 2012. A line was drawn in at the 25% level. When correlations are below that figure, it’s supposed to indicate a stock picker’s market (the term being used to indicate the times when it will pay to be a good stock selector). Unfortunately, there’s no evidence to support that statement.
It’s important to understand that correlations do not matter in determining if active managers have a good opportunity to outperform their benchmarks. Correlation shows the directional movement of stocks, not the magnitude of their movement.
Magnitude is shown by the dispersion of returns—the size of differences in the returns of individual stocks/asset classes. The greater the dispersion, the greater the opportunity becomes for active managers to add value by overweighting the winners and avoiding the losers.
Thus, it’s the dispersion of returns that we should examine, not the correlations, to see how high a hurdle there is for active management.
In each of the prior five calendar years (2007-2011), which included bull, bear and flat markets, the degree of dispersion was such that at least two-thirds of all stocks either led or trailed the index by more than 10 percentage points—with the range being a low of 67% and a high of 79%. Clearly, there was plenty of opportunity for active managers to add value.
Opportunities For Active Managers
Here’s further evidence. In 2012, the year in which the previously mentioned article and its claims regarding a stock-picker’s market appeared, the Vanguard 500 Index Fund (VFINX) returned 15.8%. Contrast that return with the return of the five best-performing stocks in the S&P 500 Index as presented in the table below:
In addition to the five stocks that returned more than 100%, 12 stocks returned more than 75%, and the top 25 stocks all returned more than 60%. Thus, active managers had plenty of opportunity to outperform the index by overweighting this group.
Active mutual fund managers also had plenty of opportunity to outperform the index by underweighting the biggest losers. The table below shows the performance of the five worst performers:
In addition to the five stocks that lost at least 44%, a total of 12 stocks lost at least 30%, and 25 stocks lost at least 18%.
SPIVA Reveals The Truth
Clearly, active managers had plenty of opportunity to add value—they just didn’t do it. And when they’re able, they don’t do so with any persistence, as the S&P Dow Jones Indices Versus Active (SPIVA) scorecards demonstrate year after year.
In 2012, the SPIVA scorecard showed performance lagged behind the benchmark indices for 63.3% of large-cap funds, 80.5% of midcap funds and 66.5% of small-cap funds. If any persistence in active management exists, it’s the persistent failure to outperform.
The latest SPIVA scorecard, for example, from year-end 2016, found the same results it always shows.
It’s my experience there is a large group of investors who just cannot accept the idea that smart portfolio managers, working hard, aren’t likely to outperform simple benchmark indices. To them, it makes no sense that smart people cannot earn better returns than the averages. After all, their experience tells them that in all other endeavors, more skilled people outperform those with less skill.
The problem is they fail to understand that the nature of the competition in investing is very different than, say, in chess or tennis, where even very small differences in skill can lead to large differences in outcomes.
Chess and tennis are one-on-one competitions, while investing is not. Investors are not competing against other individual investors (in which case, the smartest would likely outperform). Instead, they are competing against the collective wisdom of the market, a much more difficult competitor.
Today it’s estimated that as much as 90% of all trading is done by institutional investors. There are just not enough victims (unsophisticated individual investors) to exploit to overcome the costs of active management. Remember that, while tennis and chess are zero-sum games (for every winner there is a loser), active management is a negative-sum game, because each investor incurs costs in their efforts to outperform—and active management’s costs are greater than the costs of passive vehicles (such as index funds).
Thus, in aggregate, active management must be a loser’s game, regardless of whether markets are efficient or inefficient, or whether they are in a bull or a bear phase. It’s what Vanguard founder John Bogle called the “cost matters hypothesis.”
So, I remain confident that, at the end of 2017, active management’s apologists will come up with explanations for why it once again underperformed, along with the forecast that 2018 will be different, and the reasons that will be the case.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.