Swedroe: Persistence Remains Elusive

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 isn’t significantly greater than should be randomly expected, investors cannot separate skill-based performance (which might be able to persist) from luck-based performance (which eventually runs out). The following are some of the highlights from the just-released December 2017 persistence scorecard, with data through September:

• Out of 563 domestic equity funds in the top quartile as of September 2015, only 6.4% managed to stay in the top quartile at the end of September 2017. Furthermore, 6.5% of the large-cap funds, 1.2% of the midcap funds and 6.8% of the small-cap funds remained in the top quartile. Given that, randomly, we would expect 6.3% to do so, we have evidence both that it’s very hard to separate skill from luck in fund performance, and that relying on past performance is a fool’s errand.
• Over three-consecutive 12-month periods ending September 2017, just 19.5% of large-cap funds, 18.5% of midcap funds and 23.1% of small-cap funds maintained a top-half ranking. Randomly, we would expect 25% to do so.
• Only 4.7% of large-cap funds, 6.5% of midcap funds and 5.5% of small-cap funds maintained top-half performance over five-consecutive 12-month periods. Randomly, we would expect 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. Of 371 funds in the bottom quartile, 14.6% moved to the top quartile over the five-year horizon, while 23.5% of the 371 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 funds in the worst-performing quartile were much more likely to be liquidated or merged out of existence, highlighting the importance of making sure survivorship bias isn’t in the data.

The results for fixed-income funds were marginally better. For example, over the five-year measurement horizon, a lack of persistence existed among top-quartile funds in most fixed-income categories, with few exceptions. Of 13 fixed -income fund categories, funds investing in long-term government bonds, short-term investment-grade bonds and high-yield bonds were the only groups in which the report observed a noticeable level of persistence. In the other eight fixed-income categories, there were no funds with five years of persistence in the top quartile.

Some Investors Catching On

The good news is that investors are reacting to active management’s persistent failure. Vanguard found that, as of October 2017, investors had indexed $10.2 trillion, about 20% of global equity assets, almost double the percentage from 10 years earlier. In addition, 2017 was the fourth-straight year money flowed into passive funds and out of active funds.

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 the 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.