Swedroe: Persistence Hard To Come By

August 03, 2018

Since 2002, S&P Dow Jones Indices has published its biannual Indices Versus Active (SPIVA) reports, which compare the performance of actively managed equity funds to their appropriate index benchmarks. It also puts out a pair of scorecards each year that focus on persistence of performance.

This is an important issue, because if persistence is not significantly greater than should be expected at random, investors cannot separate skill-based performance (which might be able to persist) from luck-based performance (which eventually runs out).

Following are some of the highlights from the just-released July 2018 persistence scorecard, with data through March 2018:

  • Out of 557 domestic equity funds in the top quartile as of March 2016, only 2.3% managed to stay in the top quartile at the end of March 2018. Furthermore, only 0.9% of the large-cap funds, no midcap funds and 3.9% of the small-cap funds were able to remain in the top quartile over that period. Given that, randomly, we would expect 6.3% to do so, we have evidence both that it’s hard to separate skill from luck in fund performance and relying on past performance is a fool’s errand.
  • Over three-consecutive 12-month periods ending March 2018, 22.1% of large-cap funds, 7.6% of midcap funds and 13.5% of small-cap funds maintained a top-half ranking.
  • Randomly, we would expect 25% to do so.
  • Only 11.4% of large-cap funds, 1.2% of midcap funds and 3.6% of small-cap funds maintained top-half performance over five-consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.3%.

The bottom line is that, basically, there was no evidence of persistence in performance greater than randomly expected among active equity managers. Making matters worse is that a stronger likelihood existed of the best-performing funds becoming the worst-performing funds than vice versa.

Other Angles

Of 364 U.S. equity funds in the bottom quartile, 17% moved to the top quartile over the five-year horizon, while 25.8% of the 364 funds in the top quartile moved to the bottom quartile during the same period.

The one area in which the report found evidence of persistence was that across all market-cap categories, funds in the worst-performing quartile were much more likely to be liquidated or merged out of existence, highlighting the importance of making sure that survivorship bias isn’t present in the data.

The five-year transition matrix shows that 33.8% of large-cap funds, 34% of midcap funds and 29.1% of small-cap funds in the bottom quartile disappeared.

Results for fixed-income funds were marginally better. For example, over the five-year measurement horizon, the report documented a lack of persistence among top-quartile funds in most fixed-income categories, but with a few exceptions.

Of 13 fixed-income categories, funds investing in long-term government bonds, long-term investment-grade bonds, short-term investment-grade bonds, mortgage-backed securities, general municipal debt and California municipal debt were the only six groups for which the report observed a noticeable level of persistence. In the remaining seven categories, the top quartile contained no fixed-income funds with five years of persistence.

The Paradox

The year-end 2017 U.S. SPIVA report showed that over the latest 15-year investment horizon, 92% of large-cap managers, 95% of midcap managers and 96% of small-cap managers failed to outperform on a relative basis, when calculating performance data with results from closed funds included.

That’s even before considering the fact that the largest expense for the typical actively managed fund is taxes. According to data from the Investment Company Institute, an industry group representing mutual funds, in just the past three years, 2,229 mutual funds and ETFs closed. You can be sure they haven’t closed due to good performance.

Despite the persistent failure of active managers to outperform, according to Thomson Reuters Lipper, active funds of all kinds, including money market funds, manage about $15.4 trillion. That’s 2.3 times the $6.7 trillion managed by passive funds and ETFs.

The good news is that investors are reacting to active management’s persistent failure. 2017 was the fourth-straight year money flowed into passive funds and out of active funds. In 2018’s first quarter, actively managed funds, excluding money market funds, experienced net withdrawals of $8.6 billion while their passively managed counterparts took in nearly $107 billion.

Unfortunately, many institutional investors (such as endowments and pension plans) still engage in the practice of selling funds, or firing managers, once they have underperformed the market over the previous three years, typically replacing them with funds or managers that have recently outperformed. They do this while ignoring not only the evidence that past performance has almost no predictive value, but also that research that has found the hired managers go on to underperform the fired managers.

An explanation for this seemingly strange outcome involves evidence of mean reversion in mutual fund performance. Robert Arnott, Vitali Kalesnik and Lillian Wu, authors of the January 2018 study “The Folly of Hiring Winners and Firing Losers,” found it can be explained by the tendency for underperforming managers to hold cheaper assets, with cheaper factor loadings, setting them up for good subsequent performance, whereas recently winning managers tend to hold more expensive assets.

Summary

The SPIVA scorecards provide powerful evidence regarding the persistent failure of active management’s ability to persistently outperform. They also provide compelling support for Charles Ellis’ observation that, while it’s possible to win the game of active management, the odds of doing so are so poor that it’s imprudent to try—which is why he called it “the loser’s game.”

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

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