The Myth Of Active Mgmt’s Good Year

Active managers in U.S. stocks had an awful year in 2014, according to CNN Money. It reported:

“A staggering 86 percent of active large-cap fund managers failed to beat their benchmarks in the last year, according to an S&P Dow Jones Indices scorecard released on Thursday. And no, that wasn't a one-off blip either. Nearly 89 percent of those fund managers underperformed their benchmarks over the past five years and 82 percent did the same over the last decade, S&P said.”

But in May of this year, CNN Money reported that only 51 percent of active managers underperformed. A 30-plus percentage point drop in underperformance would appear to indicate that active management was having a better year. Appearances can be deceiving, though.

The Benchmarking Game

Picking benchmarks involves judgment, and that human judgment causes the appearance of vastly different performance of active managers relative to those benchmarks. In 1991, Nobel Laureate William Sharpe wrote an amazingly simple paper titled “The Arithmetic of Active Management.” In the paper, he proves the following assertion:

“Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

As I put it to clients, outside of Lake Woebegone, 90 percent of managers cannot be above average, and the vast majority of money in the stock market is professionally managed and advised.

Behind The Curtain

In looking at U.S. large-cap core funds, the S&P 500 is the typical benchmark. Reviewing Morningstar data, over the past decade, the percentage of active large-cap core besting the S&P 500 (total return including dividends) ranged from a high of 57 percent to a low of 17 percent.

While I haven’t conducted a study, I suspect the extreme differences can be explained by several factors. One must remember that funds categorized as U.S. large-cap core are typically not purely in that category, as the S&P 500 is. They have other holdings as well.

1. International stock performance. Domestic stock funds often own some foreign stocks. When international stocks outpace the U.S., it gives a boost versus a pure U.S. stock index. In the past several years, international stocks have caused a drag.
2. Mid- and small-cap performance. Large-cap funds often also own some mid- and small-cap stocks, while the S&P 500 is pure large-cap by most definitions. We know that the size factor has delivered excess returns. Small-cap was a drag versus the S&P 500 last year.
3. Cash. Active funds typically have more cash on hand as investors tend to move in and out more frequently than those in index funds. In up markets, cash is a drag, but it can help in down markets.

There is, of course, one other reason that mutual funds and ETFs vary from index performance. That’s because roughly only about 25 percent of U.S. stocks are owned by mutual funds and ETFs. Thus, the other 75 percent can either outperform or underperform the index.

What This Means
Will the remainder of this year and future years be good or bad for active investing? Properly measured, it must be bad relative to indexing. But the appearance is likely to look good for active, if:

1. International stocks top U.S.
2. Small- and midcap stocks best large-cap
3. Stocks decline in value (cushion from extra cash)

Sharpe notes, “The best way to measure a manager's performance is to compare his or her return with that of a comparable passive alternative.” This would mean using weighted average benchmarks of several indexes that include international, size, cash and other factors. Doing so would likely show a more stable proportion of active besting passive.

Today roughly 37 percent of money in U.S. stock funds is in index funds, and it keeps growing. I’m even getting a bit nervous that indexing can become too big. But William Bernstein is probably right that all it takes to keep markets efficient are “two dentists having lunch in Lubbock.”

Still, if you think active bests passive under certain conditions, go for it! Please know you have my thanks for keeping markets efficient.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for AARP publications.