Swedroe: Active Arguments Disproved

The author responds to an article arguing the merits of active investing.

A reader asked me to comment on a recent Forbes article titled “Active Versus Passive Management: Which Is Better?” The author, contributor Peter Andersen, asks this question while observing that, in 2014, the vast majority of active fund managers underperformed the S&P 500 Index.

However, he also notes that there have been periods “where active management of large-cap equity funds stunningly outperformed simple indexing.”

Andersen, who is the chief investment officer at Congress Wealth Management, presents a graph in which he demonstrates “evidence” showing the percentage of active managers who outperformed the passive S&P 500 index investor each year. His graph shows various periods since 1989 when active managers outperform the S&P 500. I thought I’d share my response.

William Sharpe & Basic Math

We’ll begin by noting there are several problems with Andersen’s graph. It’s a good example of how investors can easily be misled by manipulation of the data. There are, however, further issues with the arguments he offers. The first is one of basic math.

In 1991, William Sharpe wrote a seminal paper, “The Arithmetic of Active Management.” Using simple arithmetic, he demonstrated that active management, in aggregate, must be a loser’s game. On average, active managers must underperform proper benchmarks.

Sharpe’s “proof” demonstrated that this holds true not only for the broad market, but also when the market is in a bull or bear phase. It also must hold true for subsectors of the market, such as small stocks or emerging market stocks. The reason is simple: All stocks must be owned by someone.

If one group of active investors outperforms because they overweighted the top-performing stocks, another group of active investors must have underperformed because they underweighted those very same stocks. In aggregate, on a pre-expense basis, active investors earn the same market rate of return as passive investors. But because they have higher expenses, they earn lower net returns, which are the only kind you get to spend.

Sharpe concluded: “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.” And that leads us to the next problem.

Dunn’s Law Of Style Purity

The second problem with Andersen’s position is related to what’s often referred to as Dunn’s law, or what we can call the law of “style purity.” Dunn’s law states that when an asset class does well, index funds will outperform active managers in that asset class. However, when an asset class does poorly, active managers have a greater chance to outperform their benchmark index.

The logic is simple. Index funds generally achieve the greatest exposure to the relevant risk factors responsible for the vast majority of the returns. Active fund managers, on the other hand, often style-drift. They lose exposure to the targeted asset class, whether it’s the winning or the losing performer.

In other words, when large-cap stocks are the leading asset class (as they were in 2014), index funds will likely outperform large-cap active managers. And we see results similar to those in 2014 in years like 1995 through 1998, when the S&P 500 outperformed the vast majority of active managers each year.

The reverse is also true. From 1977 through 1982, small-caps outperformed large-caps by about 16 percentage points per year. Except for one year during that period, at least 60 percent of active managers outperformed the S&P 500.

Again, the reason for this is simple. Active managers, even the active managers of large-cap mutual funds, tend to own smaller-cap stocks than those in the S&P 500. Thus, they held some of the “outperformers,” unlike in 2014, when they held some of the “underperformers.”

Style Drift

In periods when the S&P 500 outperforms, you hear claims like, “It just wasn’t a stock-picker’s year.” Stock picking has virtually nothing to do with it. It’s all about asset allocation. Active managers lose (or win) because they style-drift. In periods when small-caps outperform the S&P 500, active managers undeservedly claim victory for their stock-picking skills.

Again, stock picking had little or nothing to do with it. The academic evidence is very clear that, as a group, active managers fail miserably at intentionally style-drifting to the asset class that will outperform.

In the graph that Andersen presents, each period in which you see the majority of active managers outperforming corresponds to a period of small-cap outperformance. And in each of those periods, you can be sure the majority of small-cap active managers underperformed their respective benchmarks, such as the S&P 600 or the CRSP 6-10 Index. Those are the proper benchmarks, not the S&P 500.

But there’s another big issue with the article and the logic it employs. See if you can spot it.

Here’s what Andersen proposes: “When market participants become frustrated by the lack of outperformance of active management, some exit the active arena, choosing instead to index. That very exit from the active arena sets the stage for the remaining active managers to outperform. The siren song of active outperformance then lures those participants back in the game. But when everyone piles into active management, the ability to gain an information advantage diminishes, causing the cycle of switching back to passive again. And thus the cycle continues.” But there is more than one problem with this idea.

Problematic Logic

The first problem is that there’s been a highly persistent trend over the past 20 years toward indexing, or passive investing in general. It has been gaining market share year after year. Thus, there’s no cyclicality in the percentage of players entering and leaving active management. So that idea is wrong.

Second, there’s simply no evidence to support the cyclical concept Andersen proposes. In fact, as my co-author, Andrew Berkin, and I present in our new book, “The Incredible Shrinking Alpha,” the evidence from various studies shows that the percentage of active managers outperforming their appropriate risk-adjusted benchmarks has been falling on a persistent basis.

One study we cite found that, during the past 20 years, the percentage of active managers generating statistically significant alphas has fallen from about 20 percent to just 2 percent. There’s no cycle here at all, just a persistent trend of increasing failure.

In addition to the evidence not being supportive, I suggest the logic is wrong. It seems likely that those abandoning active management in favor of passive strategies will be investors who have had poor experiences with active investing. In other words, they’re the ones who have lost the game of active investing. Thus, it seems logical to conclude that the remaining players are likely to be the ones with the most skill.

After all, if an active investor’s outperformance is the result of good luck (and the research indicates that it is), that good luck eventually will disappear and those investors will abandon the game. As less skilled investors abandon active strategies, the level of competition among the remaining participants will increase. As the level of competition increases, it gets harder and harder to generate outperformance sufficient to cover the higher expenses of active management.

As we explain in our book, this is what’s known as the “paradox of skill.” Yes, today’s active managers are more skilled than ever. But that makes the competition much tougher. And thus fewer and fewer succeed.

The bottom line is that there’s no real cyclicality in the percentage of active managers who outperform, at least not when you measure things properly. And there’s nothing presented in the article that should convince you that using actively managed funds is the winning strategy at any time.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.