Defending The Passive Way

September 07, 2011

Reading Paul Baiocchi’s blog, I was shocked to see the SPIVA scorecard results.

At first blush, Paul’s right: Managers claiming to have a value style beat the passive benchmark more readily than managers in other style or asset classes, especially over longer time periods.

Paul proclaimed this as gravity defying. Now, Paul’s a great analyst, but not much of a physicist, what with his references to gravity defiance. That’s because the SPIVA results speak more to dismal results among managers in other asset classes than about the great superiority of active value managers.

The selection of an active manager adds an extra layer of decision-making to investors already saddled with the difficult task of allocating their assets. The undeniable truth is that even an investor picking an active value manager still faces an uphill climb to find one that will beat the market.

To justify going active over passive, one of two things should happen. First, the investor needs to think he has a superior ability picking active managers. If that’s the case, then by all means, he should exercise his expertise and see where the chips fall.

But for those hoping to get lucky arbitrarily picking a winning manager, there must be a greater than 50 percent chance of being right. Otherwise, why bother?

With this in mind, one would think there are plenty of reasons to go with active value managers. After all, looking at the best-performing category in the SPIVA data—large-cap value—almost 65 percent of such managers outperformed the S&P 500 Value Index.

Not so quick.

Crucially, this number doesn’t truly reflect the probability of picking a winning active large-cap value manager over the longer term. That’s because of two big problems, and they change everything.

First, 20 percent of the funds that would have been part of any survey five years ago have ceased to exist. Moreover, another 38 percent have deviated away from the style they had at that time.

So, adjusting for the survivorship bias and style deviations, the actual odds of picking a winner at the beginning of the term falls to 32 percent. That’s a huge drop-off, and is something investors should take note of before diving blindly into picking active managers.

So what should investors do?

Stick to what you know. If you think value stocks are going to the moon, there are plenty of passive options, including many ETFs to choose from. Also, simply defining value is no small feat, and how you do it makes a difference, as Carolyn Hill wrote in a blog recently.

All this doesn’t mean that good active managers don’t exist. To the contrary, they are present and delivering outperformance.

Unfortunately, finding them before they deliver the outperformance is a tall task and the odds of getting lucky are against you. It turns out defying gravity is much harder than it seems.

 

 

Find your next ETF

Reset All