Swedroe: Index Funds Win Across Borders

Thanks to Standard and Poor’s Indices Versus Active (SPIVA) scorecard, investors are becoming ever-more aware both of the persistent underperformance of the vast majority of actively managed funds as well the lack of evidence showing any persistence among the minority of winners beyond the randomly expected. This increasing awareness has led to an inexorable trend in which passively managed funds are gaining market share, albeit at a snail’s pace.

The latest evidence of active fund underperformance comes from the midyear 2015 SPIVA European Scorecard. Following is a summary of the report’s key findings:

• In euro terms, over the latest 10-year period, about 92 percent of eurozone equity funds and approximately 87 percent of European equity funds trailed their respective benchmarks. The equal-weighted (asset-weighted) underperformance for eurozone equity funds was 1.6 percent (1.4 percent) per year; the equal-weighted (asset-weighted) underperformance for European equity funds was 1.2 percent (0.8 percent) per year.
• Even worse, 98 percent of European funds investing in U.S. equities underperformed over the 10-year period. Their equal-weighted (asset-weighted) underperformance relative to the S&P 500 was 2.5 percent (1.3 percent). The same percentage of European funds investing in global equities underperformed, with their equal-weighted (asset-weighted) underperformance averaging 1.3 percent (2.4 percent) per year. And, demonstrating that active funds don’t outperform in the supposedly inefficient emerging markets, 98 percent of European equity funds investing in emerging markets underperformed, with the equal-weighted (asset-weighted) underperformance being 0.9 percent (2.1 percent) per year. In other words, just 2 percent of European equity funds outperformed their benchmark index over the 10-year period. Good luck identifying the 2 percent in advance.
• Funds disappeared at an astonishing rate. Over the past 10 years, approximately 50 percent of the euro-denominated funds invested in European equities were either liquidated or merged. That can create a huge survivorship bias problem in the data, something for which the SPIVA scorecards account. Unfortunately, many others don’t.
• Although the data was better when returns were observed in pounds, all categories of U.K. funds trailed their corresponding benchmarks when viewed over a 10-year time horizon. For example, about 73 percent of large- and midcap equity funds underperformed. In the “less efficient” category of small-cap stocks, the failure rate was 85 percent. In addition, between 50 and 60 percent of sterling-denominated U.S. and European equity funds were either liquidated or merged over the past 10 years.
• For French and German equity funds, 86 percent and 83 percent, respectively, underperformed over the 10-year period.

If the debate between active and passive management was a prizefight, a TKO would have been declared by now.

Yet as compelling as the evidence on the failure of the active management industry to generate alpha may be, it’s important to note that all of the above figures are based on pretax returns. Given that the higher turnover of actively managed funds generally makes them less tax efficient, on an after-tax basis, the failure rates would likely be much higher (taxes are often the highest expense for actively managed funds).

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