Swedroe: Excuses For Active Managers

March 09, 2015

As sure as the sun rises in the east, the start of each year brings with it a fresh wave of assurances from the “gurus” who appear in the financial media that this year will be a stock picker’s year. And as sure as the sun sets in the west, the year invariably ends with various excuses for why the past year was a difficult one for active managers, and why next year will surely be different.


A perfect example of this, one that falls squarely into a category that Jane Bryant Quinn humorously called “investment porn,” is the Real Clear Markets article by Alexander Hart, “Why Active Managers Underperformed in 2014.”


We’ll review the various excuses made in the article for why active managers had a bad year, and in so doing, reveal that there really is no wizard behind the curtain.


Blaming The Small-Caps

The first excuse is that small-caps underperformed, and many large-cap managers own some small-cap stocks. Thus, their small-cap holdings dragged down their overall performance. While it’s true that many large-cap active managers hold some small-cap stocks, this excuse holds about as much water as a sieve.


To start, active managers claim that, unlike indexers, they have the ability to style drift, shifting funds to the stocks or asset classes that will outperform. Unfortunately, the evidence shows this is an advantage “fraught with opportunity”—it’s not one that active managers can systematically exploit. The failure of 80 percent of active large-cap managers in 2014 demonstrates that point.


While there have been a few years when small-cap stocks outperformed and a small majority of active large-cap funds (aided by their holdings of small-cap stocks) outperformed Vanguard’s S&P 500 ETF (VFINX), there are more years when small-caps outperformed and a majority of large-cap funds underperformed, despite their advantage in holding some small-cap stocks. (VFINX’s corresponding ETF is the Vanguard S&P 500 ETF (VOO | A-97).)


For example, of the last 10 calendar years, small-cap stocks outperformed large-cap stocks in six of them: 2006, 2008, 2009, 2010, 2012 and 2013. During those years, VFINX’s Morningstar percentile ranking was 24, 38, 54, 31, 38 and 44, respectively. The only year of the six when VFINX didn’t outperform a majority of active funds was 2009. The fund’s average ranking for the six years was 38.


Despite their advantage in holding some of those outperforming small-cap stocks, an average 62 percent of active large-cap managers underperformed in years when small-caps outperformed. And these figures contain survivorship bias.


Poorly performing funds are closed or merged out of existence. If this bias were eliminated, the relative performance of active managers would look even worse, and perhaps we wouldn’t have even a single year when VFINX underperformed a majority of the active large-cap funds.


What About The Small-Cap Managers?

We can also expose this excuse as a sham by looking at the flip side of Alexander Hart’s argument. Just as large-cap active managers would be hurt if they own small-cap stocks when they underperform, small-cap active managers who hold some large-cap stocks would benefit from the outperformance of those large-cap stocks.


Thus, we should expect to see small-cap active managers outperforming a small-cap index fund in such periods, as they benefit from their holdings of large-cap stocks. In the four calendar years of the last 10 in which small-caps underperformed—2005, 2007, 2011 and 2014—the percentile rankings of Vanguard’s Small Cap Index Fund (NAESX) were 42, 30, 44 and 14.


That’s an average ranking of 33. Despite the advantage small-cap active managers had in those years—the ability to hold some large-cap stocks—NAESX still outperformed two-thirds of its active rivals. (NAESX’s corresponding ETF is the Vanguard Small-Cap ETF (VB | A-99).)


I would add that there was only a single year in the last 10 (in 2008, NAESX’s percentile ranking was 53) when a majority of active small-cap managers outperformed a benchmark index fund. Again, keep in mind these results contain survivorship bias. It’s possible, if not highly likely, that there wasn’t a single year in which the majority of actively managed small-cap funds outperformed. One excuse exposed.


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