Second, there is nothing cyclical about the underperformance of active managers. That’s a permanent condition, and has been so for a long time.
In his brilliant, and short, 1991 paper, “The Arithmetic of Active Management,” Nobel Prize-winner William Sharpe showed why this must be the case. And each and every year, the S&P Dow Jones Indices Versus Active (SPIVA) scorecards demonstrate that the majority—in most cases a very large majority—of active managers underperform their appropriate risk-adjusted benchmarks in every asset class.
For example, the 2016 SPIVA Institutional Scorecard, which covered the 10-year period ending in 2016, found that while active institutional funds produced better results than active mutual funds, across all asset classes within the domestic equity space, the overwhelming majority of active managers lagged their respective benchmarks. For example, the percentage of institutional funds underperforming their benchmark ranged from 63% (large value) to 96% (small growth).
The results in international markets were no better, with 81% of international institutional funds failing to provide value and 84% of mutual funds failing to do so. The performance was somewhat better in international small stocks, where “only” about two-thirds of active institutional and active mutual fund managers underperformed.
In the supposedly inefficient asset class of emerging markets, which has traditionally been thought to be one area where active management can add value, 79% of institutional managers fell short of the benchmark. Mutual funds performed even worse, with 86% of them underperforming.
And the results in bond markets were not encouraging either. In the 13 bond categories examined, mutual fund underperformance ranged from 59% (investment-grade bonds) to as high as 97% (high-yield bonds). For institutional managers, the results were similar.
Looking At Factors
I’ll now address Marks’s comments on investment factors, smart beta and the fund construction rules of passive vehicles.
First, I agree with Marks that a fund’s construction rules matter—a great deal. Furthermore, not all passively managed funds are created equal. Some have superior fund construction strategies.
That said, fund families such as DFA, AQR Capital Management and Bridgeway Capital Management, the three fund families my firm, Buckingham Strategic Wealth, uses to implement equity strategies, all base their fund construction rules on decades of academic, peer reviewed research.
This research shows which factors (traits or characteristics of stocks) demonstrate: persistence of a premium over long periods of time and across economic regimes; pervasiveness across the globe; robustness to various definitions; implementability (meaning they survive transactions costs); and have intuitive risk- or behavioral-based explanations giving us confidence that the premiums are likely to persist.
Once identified, specific portfolio construction rules are created and followed. And they also use patient-trading strategies to avoid some of the negatives of pure indexing.
Second, much of the academic research that has uncovered these factors (or what is often referred to as “smart beta”) can be viewed as reverse engineering. It identified the characteristics (such as low price-to-cash flow ratio, earnings, EBITDA or book value) that the most successful active managers have exploited. Once identified, other investors can access the same factors, though in a more highly diversified way.