Swedroe: Avoid The Loser’s Game

In a recent discussion on the website of Advisor Perspectives, a widely read site for industry professionals, I was asked about the performance of active value managers. Specifically, the question was: While, overall, the evidence clearly demonstrates that active management is highly likely to underperform well-designed passively managed funds, are outcomes any different for active value managers? 

My response was a simple test to examine Morningstar rankings earned by the passively managed value funds of Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) Using these funds means that no individual stock selection or market timing is involved, and that there’s no hindsight bias at work here.

The table below shows the 15-year percentile rankings for DFA value funds as of Jan. 31, 2014. When examining the data, keep in mind that Morningstar rankings contain survivorship bias, meaning they capture the results of only those funds that have survived the entire 15-year period. Given that about 7 percent of all funds disappear every year, if the rankings were corrected for that bias, DFA’s funds would have placed even higher.

Even without accounting for survivorship bias in the data, with an average ranking of just more than 12, the DFA’s value funds outperformed about 88 percent of all actively managed value funds. And given that actively managed funds are typically less tax efficient, it’s likely that, after both these factors are taken into account, DFA’s rankings would have been higher still.

The SPIVA Results

For further evidence on the performance of active value managers, we can turn to the latest SPIVA U.S. Scorecard, from midyear 2014, provided by Standard and Poor’s. We’ll examine the data for the five-year period ending June 2014.

• With the S&P 500 Value Index as the benchmark, 82 percent of active value funds underperformed. The index returned 18.5 percent and the average (equal-weighted) active fund returned 16.8 percent, an underperformance of 1.7 percentage points per year. On an asset-weighted basis, the figures were the same.
• With the S&P 400 Mid-Cap Value Index as the benchmark, 81 percent of active value funds underperformed. The index returned 21.9 percent and the average (equal-weighted) active fund returned 20.2 percent, an underperformance of 1.7 percentage points. On an asset-weighted basis, the figures were 21.7 percent and 19.7 percent, respectively, producing even larger underperformance of 2.0 percentage points a year.
• With the S&P 600 Small-Cap Value Index as the benchmark, 78 percent of active value funds underperformed. The index returned 21.7 percent and the average (equal-weighted) active fund returned 19.7 percent, an underperformance of 2.0 percentage points. On an asset-weighted basis, the figures are 21.7 percent and 19.6 percent, respectively, producing slightly larger underperformance of 2.1 percentage points a year. Note the largest underperformance came in supposedly more inefficient small-cap stocks.          

Increasingly A Loser’s Game

These results provide a powerful example of just how extensive a loser’s game active management can be, even for value investors. Making matters worse is that there’s compelling evidence (presented in my new book, “The Incredible Shrinking Alpha”) that the hurdles to generating alpha, or risk-adjusted outperformance, are getting higher and higher. My co-author Andrew Berkin and I provide evidence on four powerful themes:

• Academic research is turning what once was alpha into beta, or exposure to common factors, which can be accessed with low-cost, passively managed funds such as index funds, ETFs and funds from providers like DFA, Bridgeway and AQR Capital.
• The supply of victims that can be exploited is shrinking (there are fewer “suckers” at the poker table) as past losers abandon the game of active management.
• As the losers drop out, the remaining competition is getting persistently tougher to beat.
• The supply of dollars chasing the limited and shrinking sources of alpha have dramatically increased.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.