Swedroe: Top Firms Fail To Beat Passive

Despite top-level resources, the “best” consultants cannot beat a passive approach. 

In the quest for money managers that can outperform appropriate benchmarks, one of the theoretical advantages that large pension plans have over individual investors is that they often hire professional consultants to help them perform due diligence in interviewing, screening and ultimately selecting the very best of the best.

You can be sure that these consultants have thought of every conceivable screen to identify the best fund managers. Surely, they have considered not only managers’ performance records, but also factors such as their management tenure, depth of staff, performance consistency (to make sure that a long-term record is not the result of one or two lucky years), performance in bear markets, consistency of strategy implementation, costs, turnover, and so on. It’s unlikely there is something that you or your financial advisor would think of that they hadn’t already considered.

Two Top Firms Vs. Passive Management

Two of the leading firms in this space are SEI and Russell. In addition to providing investment consulting to pension plans and other institutional investors, both firms also offer advice to investment advisors on selecting the best active managers. Moreover, they have their own family of actively managed mutual funds. Many financial advisors use these funds. In fact, Morningstar shows that SEI’s mutual funds have about $94 billion in assets under management and Russell’s funds have roughly $40 billion. Obviously, people believe that Russell and SEI must be able to identify future alpha generators. The question is: Is that belief justified?

I have been reporting on the results of their efforts for some time now, tracking the performance of SEI and Russell funds and comparing them to the passively managed funds of Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in the construction of client portfolios.) Every time I perform this analysis, I update fund performance figures. I started tracking their performance in 2000, so we now have 17 years of data. That’s certainly sufficient time to differentiate skill from luck.

The results continue to be both amazing and consistent. Each time I’ve run the data, both Russell and SEI not only fail to outperform, but fail to outperform in a single asset class (though this time around Russell managed to tie DFA in one asset class). Now, that’s awfully hard to do, even if you were to set out to do it (unless, of course, you simply churn accounts). Yet, both SEI and Russell have managed this feat.

The following table presents the results over the period for which we have data for all of the funds, the last 17 years (2000-2016). Where more than one version of a fund is available, the lowest-cost version is used. As you can see, actively managed equity funds from SEI and Russell underperformed DFA’s passively managed funds in every single case. It didn’t matter whether the asset class was large caps or the supposedly inefficient classes of small caps and emerging markets.

SEI vs. DFA

Using DFA’s large-cap international fund for that asset class (the DFA fund with the lowest return for the period), an equal-weighted portfolio of six DFA funds (one from each of the asset classes represented in the table) would have returned 7.1 percent. A similar SEI portfolio would have returned just 3.9 percent. That’s an underperformance of 3.2 percentage points a year.

Russell vs. DFA

Russell only has comparable funds in four of the asset classes. An equal-weighted portfolio of their funds in those four asset classes from the table would have returned 4.8 percent. An equal-weighted portfolio of DFA funds (again in those same four asset classes) would have returned 5.7 percent, outperforming the Russell portfolio by 0.9 percentage points.

It is also important to note that the underperformance of both active mutual fund families is much greater than the difference in their expense ratios versus DFA’s, demonstrating that the cost of active management goes well beyond just the visible expense ratios of funds.

Given the considerable resources that these fund families have at their disposal, the evidence demonstrates just how difficult it is for active managers to generate alpha. If these firms cannot do it, what are the odds that you or your advisor can? This type of evidence is why active management is called a loser’s game. It’s not that you cannot win. It’s that the odds of winning are so low that it is not prudent to try.

Further Evidence

Scott D. Stewart, John J. Neumann, Christopher R. Knittel and Jeffrey Heisler, authors of the  study, “Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors,” which appeared in the November/December 2009 issue of the Financial Analysts Journal,  examined whether or not the investment decisions of plan sponsors contribute to their asset values. The study, utilizing a data set covering 80,000 yearly observations of institutional investment product assets, accounts and returns over the 24-year period from 1984 to 2007,  encompassed the broad spectrum of both domestic and international equities and domestic and international bonds. The results are shocking, though they won’t surprise believers in the efficiency of markets.

The following is a summary of its findings:

• While plan sponsors may believe they are acting in their stakeholders’ best interests, the results show that when they make rebalancing or reallocation decisions, on average they are destroying value.
• Investment products receiving contributions subsequently underperform products experiencing withdrawals over 1-, 3- and 5-year periods.
• For investment decisions among equity, fixed income and balanced products, most of the underperformance can be attributed to product selection decisions as opposed to asset allocation decisions. However, both types of decisions subtracted value.
• Much like individual investors who switch mutual funds at the wrong time, institutional investors don’t appear to create value from their investment decisions.

The authors estimated that allocation decisions by plan sponsors resulted in losses of more than $170 billion over the period studied—an average cost of more than $7 billion a year.  Even this horrific figure understates the damage because it’s gross of any transition costs. Clearly, the plan beneficiaries would have been better served if plan sponsors had acted as if they were Rip Van Winkle. Even more would have been saved if they had simply chosen passively managed funds in the first place and then stayed the course.

A Rational Approach
It’s worth noting that the plan sponsors were acting in what most people would agree was a rational way. In their hiring decisions, they placed great importance on historical performance measures, performance trends and product attributes. However, despite hiring managers with large, persistent and even long-term records of delivering alpha relative to appropriate benchmarks, the record demonstrates that relying on past performance is costly.

Compared to individual investors, institutional plan sponsors have a much higher level of sophistication, typically staffed with professionals with years of experience and advanced degrees. Either on their own, or using consultants such as SEI and Russell, they devote considerable time and resources to selecting asset classes and products that are expected to perform well in the future. Yet, the record demonstrates that their efforts have proven counterproductive.

Unfortunately, the experience of 401(k) plan sponsors isn’t any better. Edwin J. Elton, Martin J. Gruber and Christopher R. Blake,  authors of the study, “How Do Employers’ 401(k) Mutual Fund Selections Affect Performance?”, which appeared in the January 2013 issue of Center for Retirement Research, looked at the performance of the plan administrators in their fund selections. They found that the mutual funds plan administrators choose underperform benchmark index funds. Thus, participants would be better served if the plans offered passive, instead of active, choices. They also found that plan administrators are performance chasers— they fire poorly performing funds and replace them with “hot” funds. However, all the activity didn’t add any value.

Why Keep Repeating the Same Mistakes?

The question then remains: Why do plan sponsors keep doing what Einstein said was the definition of insanity—repeating the same behavior and expecting different results? Why do they keep hiring managers with past alpha only to end up firing them because the past isn’t prologue? The authors of “Absence of Value” hypothesized that it’s because they find comfort in extrapolating past performance despite their own experiences that excess performance is random.

Perhaps the real answer is that plan sponsors need to justify their existence. If they recommended abandoning active managers in favor of passively managed funds and adhering to their asset allocation plan, many would no longer be needed. One of our most famous economists, Paul Samuelson, put it this way: “[A] respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business—take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed. Few people will commit suicide without a push.” 

The issue of the performance of plan sponsors is of great importance given the dollars involved. In addition, in the case of public plans, future taxpayers will have to bear the burden of the losses incurred by plan sponsors. It’s time that the process of investment manager selection by plan sponsors changes.

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