Every year, the markets provide us with lessons on the prudent investment strategy. Many times, markets offer investors remedial courses, covering lessons it taught in previous years. That’s why one of my favorite sayings is that “there’s nothing new in investing, only investment history you don’t yet know.”
2018 supplied 11 important lessons. As you may note, many of them are repeats from prior years. Unfortunately, too many investors fail to learn them—they keep making the same errors. We’ll begin with my personal favorite, one that the market, if measured properly, teaches each and every year.
Lesson 1: Active management is a loser’s game.
Despite an overwhelming amount of academic research demonstrating that passive investing is far more likely to allow you to achieve your most important financial goals, the vast majority of individual investor assets are still held in active funds. And unfortunately, investors in active funds continue to pay for the triumph of hope over wisdom and experience.
Last year was another in which the large majority of active funds underperformed despite the fact that the industry claims active managers outperform in bear markets. In addition to their advantage of being able to go to cash, active managers had a great opportunity to generate alpha through the large dispersion in returns between 2018’s best- and worst-performing stocks.
For example, while the S&P 500 Index lost 4.4% for the year, including dividends, in terms of price-only returns, the stocks of 10 companies in it were up at least 42.6%. The following table, with data from S&P Dow Jones Indices, shows the 10 best returners.
To outperform, all an active manager had to do was to overweight those big winners, each of which outperformed the index by at least 47%. On the other hand, 10 stocks lost at least 49%, with the worst performer losing 67% on a price-only basis.
To outperform, all an active manager had to do was to underweight, let alone avoid, these dogs.
It’s important to note that this wide dispersion of returns is not at all unusual. Yet despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform. The following table shows the Morningstar percentile rankings for funds from two leading providers of passively managed funds, Dimensional Fund Advisors and Vanguard, in 2018 and over the 15-year period ending December 2018. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
Keep in mind that Morningstar’s data contains survivorship bias, as it only reflects funds that have survived the full period. The bias is significant, as about 7% of actively managed funds disappear every year, with their returns getting buried in the mutual fund graveyard. Thus, the longer the period, the worse the survivorship bias becomes, and at 15 years, it’s quite large.
For example, performing the same analysis at the end of 2016, I found that, while the average Vanguard fund had a 15-year Morningstar ranking of 36 and the average Dimensional fund had a ranking of 16, once I accounted for the survivorship bias, Vanguard’s ranking improved to 21 and Dimensional’s to 10. For taxable investors, the data is even more compelling, because taxes are typically the highest cost of active management. Thus, the survivorship-bias-free, after-tax rankings for Vanguard’s and Dimensional’s funds would be significantly better.
The results make it clear active management is a strategy that can be said to be “fraught with opportunity.” Year after year, active managers come up with an excuse to explain why they failed, and then argue that next year will be different. Of course, it never is.