Every year, the market provides us with important lessons on the prudent investment strategy. Many times, the market will offer investors remedial courses, covering lessons that it has already delivered in previous years.
That’s why one of my favorite sayings is that there’s nothing new in investing; there is only investment history you don’t yet know.
Last year supplied us with 10 lessons. As you may observe, many of them have appeared before. Unfortunately, a lot of investors fail to learn from them. They tend to keep repeating the same errors, which is what Einstein called the definition of insanity. That said, our first lesson from 2015 is that active management remains a loser’s game.
Lesson 1: Active Management Is a Loser’s Game
Despite an overwhelming amount of research to the contrary, InvestmentNews reported in January 2014 that an astonishing 75% of financial advisors they queried believed active managers would outperform. While the S&P 500 Index returned just 1.4% in 2015, active managers had great opportunity to generate alpha, as there was a very large dispersion in returns between the index’s best and worst performers.
For example, there were 10 stocks in the index that returned at least 46.6% and 25 that returned at least 34.2%. All an active manager had to do to outperform was overweight these superperformers.
On the flip side of the coin, there were 10 stocks in the index that lost at least 55.6% and 25 that lost at least 45.8%. To outperform, all an active manager had to do was underweight, let alone avoid, these dogs.
|The 10 Best S&P 500
Performers In 2015
|Return (%)||The 10 Worst S&P 500
Performers In 2015
|Netflix Inc.||134.4||Chesapeake Energy||-77.0|
|Activision Blizzard||92.1||Southwestern Energy||-74.0|
|NVIDIA Corp.||64.4||Freeport-McMoRan Copper & Gold B||-71.0|
|Cablevision Systems||54.6||HP Inc.||-70.5|
|VeriSign Inc.||53.3||Fossil Group||-67.0|
|Hormel Foods||51.8||Kinder Morgan||-64.7|
|First Solar||48.0||Micron Technology||-59.6|
|Total System Services||46.6||NRG Energy||-56.3|
Demonstrating that active management is fraught with opportunity, Morningstar data show that the Vanguard 500 Index Fund (VFINX) outperformed 77% of all active managers in the category of U.S. large blend stocks. (The Admiral Shares version of the fund, VFIAX, outperformed 80% of active managers.) And this counts only funds that survived the year (about 7% of all mutual funds disappear each year).
It’s important to note that this wide dispersion of returns is not at all unusual. Yet despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform. For the three-, five- and 10-year periods ending in 2015, Morningstar shows that VFINX outperformed 80%, 84% and 77% of surviving funds (the Admiral Shares version performed even better). Furthermore, note that as we extend the time horizon, the survivorship bias increases. Thus, the reality is that active managers did significantly worse than these figures demonstrate.
Looking at other asset classes, we find similar results. The table below shows the performance rankings for Vanguard’s U.S. large value index fund (VIVAX), its small-cap index fund (NAESX) and its U.S. small value index fund (VISVX).
Morningstar Percentile Ranking
|Vanguard Value Index (VIVAX)||17||10||15||32|
|Vanguard Small Cap Index (NAESX)||38||30||24||15|
|Vanguard Small Cap Value Index (VISVX)||38||7||6||21|
Again, the Admiral Shares versions of these funds would have performed even better.
These results show that active management is a strategy fraught with opportunity. Year after year, active managers come up with an excuse to explain why they failed that year, and then assert that next year will be different. Of course, it never is.