Swedroe: Active Won’t Save Your Retirement

Russell Investments is one of the largest asset managers in the world. Morningstar reports that, as of the close of July, it had more than $41 billion in assets under management.

However, the firm’s impact goes well beyond its AUM; Russell is one of the largest players in the world of investment consulting. It provides consulting services to pension plans and other institutional investors, as well as advice to investment advisors on selecting the best active managers.

An Argument For Active

Jeff Hussey, Russell’s global chief investment officer, in a piece titled “Active, Passive and the Low-Return Imperative,” argued that, given the current high valuations for equities and, thus, low forward-looking return expectations, he believes investors “cannot afford to ignore any investment strategy that may offer incremental return, take on risks they do not expect to get paid for or disregard implementation efficiency.”

He writes: “So many investors are currently focusing on reducing fees as a way to potentially increase the actual performance received. But prioritizing fees can cause investors to rotate out of actively managed investments into passive ones—thereby decreasing the likelihood of achieving anything more than the index-based return.”

He adds: “Passive investing alone will never outperform the market. If the markets are performing very well, then passive may be the best way to go. But what happens when markets are in a low-return environment like they are today?”

Hussey then offered three suggestions:

• “Net-of-fee alpha from active management—Passive, by its nature, will underperform the market—because it tracks the market, but then includes fees. It cannot beat the market. And any exposure to the market includes exposure to risk. Active management, while it also inherently includes risk and fees, provides the potential for outperformance….
• Targeted exposures—Delivering on investor outcomes in a low-return environment requires access to more exposures, not less. But we believe gaining access to precise exposures at the right time requires skill. And we believe that these niche market segments—such as infrastructure, emerging markets, and commodities, among others—lend themselves to providing potential opportunity when gauged through the lens of highly specialized active managers.
• Dynamic asset allocation—Constantly managing exposures and allocations requires a deep understanding of global markets and cycles, but it also requires 24/7 focused commitment. Be sure that your investment solutions provider has the trading and implementation capabilities to potentially take advantage of tactical upside opportunities and minimize unrewarded risk.”

Debunking The Claims

There’s nothing new about these types of claims. You hear them all the time from active managers. But do they contain any real truths?

To investigate that question, I’ll offer a different perspective on these assertions, and provide the appropriate historical evidence, so you can draw your own conclusions. I’ll begin with Hussey’s assertion that rotating out of active management reduces the likelihood of achieving anything more than the index return.

While that statement is correct, I believe it’s a deflection. What it’s deflecting is that, historically, rotating out of active management actually has increased the likelihood you will outperform the active strategy, as the S&P Dow Jones Indices Versus Active (SPIVA) scorecards regularly show.

As further evidence, I offer the following table, which shows the performance rankings of two of the leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard, for the 15-year period ending in 2016. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

Data is from Morningstar, but it has been corrected for the survivorship bias in their rankings. (The rankings you see on Morningstar’s website unfortunately show performance relative only to those funds still in existence at the end of the period.

For example, let’s say a given category had 100 funds at the start of the 15-year period and only 50 funds at the end of it because some were closed or merged into others, which we can assume was the result of poor performance. The way Morningstar calculates their rankings, the 10^th-best-performing fund in this category over this period would have a 20th%ile ranking because it ranked 10th out of 50 funds.

Correcting for survivorship bias means accounting for all the funds in the category an investor could have chosen at the beginning of those 15 years. It would give that same fund, with the same performance and over the same period, a 10th%ile ranking because it now ranks 10th out of 100 funds.) 

As you can see, Vanguard’s funds, on average, outperformed 79% of active funds and DFA’s funds outperformed 90% of them. Clearly, if you use active funds, the odds of underperforming are much greater than the odds of outperforming.

So, while rotating from active to passive management reduces the likelihood you’ll outperform the appropriate index benchmark (which many passive funds are designed to track), it also greatly reduces the chances that you’ll underperform it (which, as the evidence shows, the vast majority of active funds do).

Furthermore, the results in the preceding table are based on pretax returns. Because taxes are typically the greatest expense for taxable investors, and passively managed funds are generally more tax efficient, the DFA and Vanguard rankings would almost certainly have been much better if viewed on an after-tax basis.

The bottom line is that active management offers the possibility of outperformance, but we know the far greater likelihood is underperformance. That addresses the first of the three bullet points, net-of-fee performance.

It should also address the issues raised in the second and third bullet points, targeted exposures require skill and dynamically allocated portfolios. If evidence supporting these claims existed, we should see it in the preceding table.

Market Type Doesn’t Matter

Another mark against active management’s ability to tactically allocate is research showing that active managers historically perform just as poorly in bear markets as they do in bull markets. For example, the Spring/Summer 2009 issue of Vanguard Investment Perspectives contains a study on the performance of active managers in bear markets. The study covered the period 1970 through 2008, and defined a bear market as a loss of at least 10%. The period included seven bear markets in the U.S. and six in Europe.

Once adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.”

Vanguard’s researchers also confirmed that past success in overcoming this hurdle does not ensure future success. Vanguard was able to reach this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias.

The SPIVA data and other evidence presented here provides a strong argument against the active management industry in aggregate. But it says nothing about Russell itself. So, we’ll dive into the results of the firm’s active funds to see if its managers have unique skill that the industry overall doesn’t demonstrate.

(But first a little preview: In its 2015 annual 10-year ranking of mutual fund families, Barron’s ranked Russell last out of 52 fund families. Its 2016 10-year ranking wasn’t much better, 49 out of 53. In other words, while active management does poorly in aggregate, Russell has performed poorly relative to the average active fund family.)

Where funds are available in the same asset class, I’ll compare Russell’s performance to that of funds from DFA and Vanguard. I’ve selected these funds for informational purposes to illustrate the data, and they are not provided as a specific recommendation to purchase a particular security or as a predictor of future performance.

As always, past performance is not a guarantee of future results, and it should not be assumed that any of the securities listed were or will be profitable. The data is from Morningstar and covers the 15-year period (the longest period Morningstar shows on their publicly available website) ending Aug. 10, 2017.

In not a single case did any Russell fund outperform either a DFA or Vanguard fund. In the asset classes for which there was a comparable DFA fund, and averaging the performance of Russell’s funds where there is more than one fund in the asset class, a portfolio of Russell funds equal-weighted in those asset classes would have returned 8.2% versus 9.1% for the DFA portfolio, an underperformance of 0.9 percentage points.

The same analysis relative to the Vanguard funds shows a portfolio of Russell funds would have returned 8.6% versus 9.7%, an even worse underperformance of 1.1 percentage points.

Applying Factor Analysis

Using the analytical tools and data available from Portfolio Visualizer, I’ll put Russell’s five domestic funds in the preceding table to one more test. Factor analysis provides important additional insights because Morningstar asset class categories are very broad and active funds often style drift. The following table presents the results from the six-factor (beta, size, value, momentum, quality and low beta) regression. The data covers the 15-period from June 2002 through May 2017. Each t-statistic is in parentheses.

In every case, the Russell funds produced large and statistically significant negative alphas, with the average alpha being -1.7%.

You’ve now had a chance to view Hussey’s assertions from a different perspective, and you’ve seen the evidence. Hopefully, you’ve learned that, if the current high valuations and low bond yields result in expected returns that won’t enable you to meet your financial goals, switching from passive to active strategies is likely only to lead to even lower returns.

So, what’s the investor who needs or wants higher expected returns to do? Among the prudent strategies you could adopt would be to increase your allocations to small value stocks and also to non-U.S. developed markets and emerging markets. In each case, valuations are lower and, thus, forward-looking return expectations are higher.

Of course, such actions aren’t guaranteed to provide higher returns, and they will increase your risk of experiencing what’s known as tracking error regret (it appears during periods, which are almost certain to occur, when your returns underperform a popular index, such as the S&P 500).

However, they will likely raise your expected returns, giving you a greater chance of achieving your financial goals. And you don’t need to use active funds, and their higher costs, to implement those strategies.

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