Swedroe: Active Isn’t All Bad

October 19, 2018

Stock-picking pros aren't stupid. They're just expensive.

—John Bogle, Money Magazine: 2011 Investor’s Guide

 

There’s a large body of evidence, including Eugene Fama and Kenneth French’s study “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance, demonstrating that active management is a loser’s game— fewer actively managed funds are able to outperform, on a risk-adjusted basis, than would be randomly expected.

In a 2014 Vanguard research paper, “The Case for Index-fund Investing,”  the authors, Christopher Philips, Francis Kinniry Jr., Todd Schlanger and Joshua Hirt, found that not only do active managers fail in general, they underperform in so-called inefficient markets, such as small-cap and emerging markets.

They concluded: “Investors should not expect indexed strategies to outperform 100% of actively managed funds in a particular period. However, as a result of the zero-sum game, costs, and the general efficiency of the financial markets, consistent outperformance of any one active manager has been very rare.”

There’s also a plethora of studies, including Mark Carhart’s study “On Persistence in Mutual Fund Performance”, published in the March 1997 issue of The Journal of Finance, which have found that mutual funds with higher expenses have lower performance—and active funds are typically more expensive.

The publication of all the research on the failure of active management to outperform has led to a growing belief that a passive investment strategy beats an active strategy and the resultant rise in the popularity of index fund investing.

Newer Research

David Nanigian, associate professor of finance at Cal State Fullerton, contributes to the literature on the performance of actively managed versus passively managed mutual funds with his September 2018 study “The Historical Record on Active vs. Passive Mutual Fund Performance.”

He evaluated the risk-adjusted performance of active and passively managed mutual funds over the 15-year period 2003 through 2017. The benchmark was the Carhart four-factor (market beta, size, value and momentum) model. Following is a summary of his findings.

First, he found that, on a value-weighted basis, index funds had alphas of -0.38%, outperforming the -1.00% alpha of active funds by a 0.62 percentage point. While the finding was not statistically significant at the 5% level (t-stat was 1.75), if the period covered were longer, perhaps it would have been the case.

In other words, if everything were the same over 30 years (and the data were available), the t-stat would be higher (and perhaps significant). Also, expense ratios are not the only things that cause negative alpha. You have to consider the cost of turnover—bid/offer spreads and market impact costs—which is generally significantly higher in active funds than index funds.

While Nanigian concluded that there was no statistical difference in performance between the two groups, I would add that while the 0.62 percentage point outperformance of the index funds was not statistically significant at the conventional 5% confidence level, it certainly is economically significant over a 15-year period!

Again, if Nanigian had examined 30 years of data, the t-stat of the difference in returns might have been significant. And that would have led to a different conclusion.

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