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.
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.
Nanigian then examined the data considering only the funds within the bottom quintile of expense ratios. He found that the index funds outperformed again, though the difference was smaller. Index funds in the bottom quintile of expenses had alphas of -0.37% compared to the -0.59% alphas of the active funds. The difference of 0.22 percentage point was not statistically significant (t-stat 0.68). This finding confirms that of prior research that found that expense ratios are strong predictors of performance.
In fact, the authors of a 2015 study by Morningstar concluded: “Fees matter. They are one of the only reliable predictors of success.”
In the April 2005 issue of the Morningstar Fund Investor, they went even further. “For starters, expense ratios are the best predictors of performance—way better than historical returns. It’s tempting to look at strong past performance and assume a fund can repeat its success, but there’s no guarantee it will. In fact, we’ve found that you’d be better off randomly picking a fund with expenses in the cheapest quartile than a fund with returns in the highest quartile and expenses in the highest quartile. Higher expenses don’t get you better management. If it did you’d expect higher-cost funds to outperform their lower-cost peers—when in fact just the opposite has happened.”
Nanigian ran a third test, the most interesting one, in which he paired each passively managed fund with an actively managed “partner.” To identify the “partner” for each passively managed fund, he first restricted the sample of actively managed funds to only those that belong to the same Morningstar category, and then chose the one fund whose expense ratio was closest to that of the passively managed fund. In the event that multiple actively managed funds were identified as eligible partners, the passively managed fund was paired with a hypothetical “fund of funds” that allocates capital equally among each of the eligible partners.
He found that the mean and median differences in the expense ratios across the fund-months were 2 basis points and 1 basis point, respectively. Nanigian’s results should not be surprising—the outcomes were almost identical. The alpha of the passive funds was -0.38% versus the -0.34% alpha of the active funds, both economically and statistically insignificant (t-stat of the difference was ‑0.10).
The finding of virtually no difference in performance of the paired funds should not really be a surprise. While the efficiency of the market prevents active managers from outperforming, it also prevents them from underperforming once expenses are considered.
It also should not have come as a total surprise that when the expenses of active funds were virtually identical to those of the index funds, the active funds had slightly outperformed. The reason is that indexing (with the exception of total market funds) has some negatives that can be avoided or minimized by intelligent design and patient trading. For example:
- The forced turnover of index funds can allow actively managed funds (such as hedge funds) to exploit that turnover by “front-running” the trades of index funds. For example, the lack of opaqueness has historically created problems for index funds that replicated the Russell 2000 Indices. An active fund could also trade patiently, minimizing trading costs, including market impact costs.
- There are many well-documented anomalies in the academic literature that long-only actively managed funds can exploit by excluding from their portfolios the stocks in the short side of the anomaly—while replicating index funds must include all the stocks in an index. This not only avoids the negative side of the anomaly, but allows them to overweight the positive side. Among the anomalies are poor risk/return characteristics of stocks in bankruptcy, very low-priced stocks, IPOs, extreme small growth stocks with low profitability and high investment, and stocks with high accruals.
- Active funds can also provide more exposure to the well-documented factors of size, value, momentum, profitability and quality than do popular indices. This could allow them to earn higher returns, possibly more than offsetting even higher expenses.
These advantages of actively managed funds can help them overcome potentially higher trading costs related to their generally greater trading activity. It’s also important to note that passively managed funds (i.e., no individual stock picking or market timing) that are not indexed can also exploit these advantages and minimize or avoid the negatives facing replicating index funds.
Evidence From Vanguard’s Active Funds
In my Advisor Perspectives article of January 12, 2016, I studied the performance of Vanguard’s low-cost actively managed funds over the 15-year period ending September 2015, and found that Vanguard’s low-cost active funds had:
- Outperformed Vanguard’s low-cost comparable index funds by an average of a 0.3 percentage point per year.
- Underperformed the Dimensional Fund Advisors fund from the same asset class by -1.2 percentage points per year (mostly due to lower loadings on the aforementioned factors).
- A four-factor alpha of 0.6% and a six-factor alpha (adding quality and low beta) of 0.1% per year.
The findings from Nanigian’s third test, using the paired funds, are consistent with findings from my study of Vanguard’s actively managed funds. When costs are comparable, active management doesn’t underperform.
His findings led Nanigian to conclude: “The practical implication of this study is that as long as investors are cost-conscious in their fund selection process, the active vs. passive choice is a moot point.” I suggest that this is not the right conclusion to draw, because it fails to consider several issues. For example:
- Indexed strategies benchmarked to broad-market indexes provide greater control of the risk exposures in a portfolio—avoiding the problem of style-drift that can occur with active managers.
- Index funds typically are more diversified than actively managed funds, reducing the dispersion of potential outcomes.
- For taxable investors, index funds are typically more tax efficient due to their lower turnover.
There’s plenty of good news here for investors on both sides of the active versus passive debate. First, if you choose actively managed funds that have similar costs to index funds, on average, your returns should be similar. That’s because of the high degree of market efficiency, which greatly limits the ability of active managers to generate true alpha.
That same high level of efficiency also limits the possibility of them underperforming by much more than their total expenses (assuming they are broadly diversified).
Active investors can also benefit from using low-cost active funds that provide higher loadings on factors than do popular index funds. The same objective can be accomplished by using passively managed but nonindexed funds, as my firm does. (We use the structured portfolios of AQR, Bridgeway and Dimensional. Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR, Bridgeway and Dimensional Fund Advisors in constructing client portfolios.)
Second, competition is driving expense ratios down across the board, both for actively managed and passively managed funds.
Third, the cost of trading has come down greatly as commissions and bid-offered spreads have fallen sharply over the past several decades. Note that lower trading costs are best captured by those who can trade patiently and avoid the forced trading that index funds incur, and the market impact costs that actively managed funds incur if they are buyers of liquidity due to a perceived need to trade quickly in order to take advantage of “mispricings.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.