Swedroe: ‘Incredible Shrinking Alpha’ Continues

Even though Wall Street tries to keep alive the debate about the merits of active versus passive investing, a clear trend has emerged over the last several decades in which investors are slowly but steadily abandoning the hope of outperformance that active management offers in favor of the certainty of earning market (not average) returns that passive management provides.

The trend has been inexorable as investors become more and more aware of the low and declining odds that active management will outperform. For example, the evidence presented in my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, shows that while 20 years ago roughly 20% of active managers were generating statistically significant alpha, today that figure is down to about 2%. And that’s even before considering the impact of taxes on taxable investors.

Midyear SPIVA Results

The results of the midyear S&P Indices Versus Active (SPIVA) scorecard are now in. And it shows the same trends identified in “The Incredible Shrinking Alpha”—active managers are finding it harder and harder to outperform their appropriate risk-adjusted benchmarks. Following is a summary of the report’s findings, which cover the period ending June 2016:

• During the one-year period, 84.6% of large-cap managers, 87.9% of midcap managers and 88.8% of small-cap managers underperformed the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600, respectively. And only one out of 10 large-cap, midcap and small-cap growth managers outperformed their respective benchmarks.
• Over the five-year period, 91.9% of large-cap managers, 87.9% of midcap managers and 97.6% of small-cap managers lagged their respective benchmarks.
• Over the 10-year period, 85.4% of large-cap managers, 91.3% of midcap managers and 90.8% of small-cap managers were unable to outperform their respective benchmarks. Even in the category where active managers fared the best—large-cap value—just 32% outperformed the S&P 500 Value Index. In every other category, at least 80.9% of active managers underperformed their respective benchmarks.
• Highlighting the problem of survivorship bias, over the five-year period, nearly 21% of domestic equity funds, 21% of global/international equity funds and 14% of fixed-income funds were merged or liquidated.

Wide Underperformance

It’s also important to point out that active funds’ underperformance gaps were generally wide. For example, on an equal-weighted (asset-weighted) basis:

• While the S&P 500 Index returned 7.4%, actively managed large core funds returned just 6.0% (6.1%).
• While the S&P MidCap 400 Index returned 8.6%, actively managed midcap core funds returned just 6.4% (7.2%).
• While the S&P SmallCap 600 Index returned 7.9%, actively managed small-cap core funds returned just 5.4% (6.1%).
• In the category of multicap funds (which tout their “advantage” to go anywhere), while the S&P Composite 1500 returned 7.5%, actively managed funds returned 5.5% (6.3%).
• Finally, while the S&P BMI U.S. REIT Index returned 7.3%, actively managed REIT funds returned 6.1% (7.0%).

Same Trend With International Equity, Fixed Income

The SPIVA report also noted that over the 10-year investment horizon, managers across international equity categories underperformed their benchmarks: 81.2% of active global funds underperformed, 80.2% of active international funds underperformed, 62.3% of active international small funds underperformed and 81.9% of active emerging market funds underperformed. In addition, only about 60% of the global and international funds managed to survive the full period.

The figures for actively managed fixed-income funds are equally bleak. For example, 95.7% of actively managed long-term government bond funds underperformed (and, on an equal-weighted basis, the 8.7% return to the index doubled the 4.2% return earned by active funds, which is quite a performance gap), 79.6% of actively managed intermediate-term government bond funds underperformed, and 77.1% of actively managed short-term government bond funds underperformed.

An astonishing 98.2% of actively managed long-term corporate bond funds underperformed (with the performance gap reflected in the 8.4% return of the index versus the 5.4% return of active funds). A nearly as astonishing 96.6% of actively managed high-yield funds underperformed (with the performance gap reflected in the 7.6% return of the index versus the 5.5% return of active funds).

In addition, 80.4% of actively managed mortgage-backed security funds underperformed, 81.8% of actively managed emerging market bond funds underperformed, 59.8% of actively managed intermediate-term corporate bond funds underperformed and 63.7% of actively managed short-term corporate bond funds underperformed. The asset-weighted returns gap was similar in each case, although somewhat smaller than when equal-weighting returns.

Perhaps the best way to summarize the findings is to again recall Yogi Berra’s famous remark: It’s deja vu all over again—only more so.

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