One of the reasons why I left institutional equities in 2012 was because I felt it was a dying business. Not only were trading commissions getting squeezed due to algorithmic trading and other technological advancements, assets under management (AUM) for active money managers was also declining due to poor performance.
Working harder and getting paid less was already demoralizing. Watching my clients I cared about work harder and underperform their respective indices made me feel like my job was pointless. When you feel like your job is pointless, it’s time to do something new.
Since the time I left my day job, the business has only gotten worse for actively managed funds. Yes, it is true that passive money managers gained a tremendous amount of assets during this time period. But there is no excitement speaking to an index fund manager or analyst because they don’t do any analysis. All they do is follow the moves of their benchmark indices. For example, if the S&P 500 removes one name from its index, so does the index fund manager.
As of 2019, the market share of passively managed equity funds has risen to 45 percent according to Bank Of America. For passively managed bond funds, the market share is roughly 25 percent. The market share gains will likely continue.
Let’s look at some active versus passive fund management performance in equities and fixed income over the past 10 years and see what we can discover.
Active Versus Passive Investing Performance
Since 2002, S&P Dow Jones Indices has been publishing the SPIVA U.S. Scorecard. The scorecard measures the performance of actively managed equity funds investing in domestic and international equity, as well as fixed-income funds, against their respective benchmarks.
The University of Chicago’s Center for Research in Security Prices (CRSP) Survivor-Bias-Free US Mutual Fund Database serves as the underlying data source for the scorecard. As the CRSP database consists of publicly traded open-ended mutual funds, the fee structure primarily reflects retail products rather than institutional accounts.
Let’s take a look at the 10-year historical performance of equities first and then fixed income second.
Equity Institutional Manager Performance
Institutional managers, in this case, are actively run funds that manage institutional money versus retail money. An example of institutional money is the firefighter’s pension of Texas or the sovereign wealth fund from Saudi Arabia that gave Softbank $45 billion in capital to help create the $100 billion Vision Fund.
The below chart highlights that the majority of Institutional Managers in every equity investment category underperform their respective benchmarks, gross and net of fees.
The categories for percentage of funds that underperformed the most include: Large-Cap Core Funds (87.82% underperformed net of fees), Mid-Cap Core Funds (85%.11%), Multi-Cap Core Funds (84.29%), Large-Cap Growth Funds (81.69%). If you want to invest in actively managed equity funds, stay away from these categories.
The categories for percentage of funds that underperformed the least include: International Small-Cap Funds (59.52% underperformed), International Funds (66.28%), Multi-Cap Value Funds (66.94%), and Large-Cap Value Funds (65.28%). If you want to invest in actively managed funds, these are the categories where you have the best chance of outperforming.
Equity Mutual Fund Performance
As you can see from the chart below, the performance across all categories looks even more dismal than the performance from actively run institutional funds.
Only in the Equity Mutual Funds list do you see 90%+ of funds underperforming in categories such as Large-Cap Core Funds (93.27%), Mid-Cap Core Funds (90.23%), Small-Cap Core Funds (92.97%), and Multi-Cap Core Funds (91.79%).
Once again, the categories where actively run equity funds underperformed the least were International Funds (81% underperformed) and International Small-Cap Funds (64.15%). But saying that only 81% of the International Funds underperformed is like giving them trophies for getting D-s on their exams.
Overall, 77.97% of large-cap mutual fund managers and 73.21% of institutional accounts underperformed the S&P 500® on a gross-of-fees basis over the 10-year horizon.
There was one bright spot in 2018, however, and that’s Mid-cap Growth funds. Mid-cap Growth funds offered the best relative performance among equity categories in 2018; an impressive 81.60% outperformed the S&P MidCap 400® Growth’s 10.34% decline last year.
See the 2018 performance chart below. Relatively speaking, 2018 was a great year for actively run equity funds compared to its 10-year history. But over the long term, sustained outperformance is virtually impossible.
Fixed Income Active Fund Performance
Now let’s look at the performance of actively run fixed income funds by Institutional Managers and Mutual Fund managers over the past 10 years. Overall, the percentage of funds underperforming by category is lower compared to actively run equity funds.
Institutional fixed income funds typically performed better than their benchmarks, gross of-fees, compared with their Mutual Fund counterparts. However, California municipal debt mutual funds posted the best relative performance figures over the 10-year horizon, gross-of fees.
But once you bake in the fees for California municipal debt mutual funds, the underperformance percentage goes from 26.32% to 36.84%, for a whopping 42% increase in the number of funds that underperformed. The percentage jump is even worse for NY municipal debt mutual funds.
In other words, fees matter, and could matter much more in fixed income since the average annual return for fixed income is lower than the average annual return for equity funds.
Why Do Investors Still Invest In Actively Managed Funds?
Based on the data, it is clear that investing in actively run equity or fixed income funds is a suboptimal financial decision over the long run. You can get lucky in the short-run, but in the long run, sustained outperformance is practically impossible.
One of the main reasons why portfolio managers of actively run funds are so rich is due to fees. One of the main reasons why Jack Bogle, founder of Vanguard was not a mega-billionaire is because of low fees. If you want to get rich, then it’s a good idea to work for an active institutional investor as a portfolio manager or analyst.
Investing in a fund that performs better over the long-run and has lower fees is a no-brainer. Yet institutional and retail money continue to invest in actively run funds due to the following reasons: 1) hope, 2) marketing, and 3) pedigree.
Investors love to gamble. Despite the data saying that buying lottery tickets is a waste of money, the lottery system is still big business. The same goes for investors who invest in actively run funds. They are gambling the funds they invest in will finally outperform and make them richer.
Investors also get sucked in by great marketing and strong branding. Beautifully crafted words can make a difference in attracting capital. Over the short-run, slick websites and touching commercials also do wonders to attract capital. Great marketing often blinds you to the actual performance numbers until it’s too late.
Finally, many investors feel better when an old guy who went to an Ivy League school is managing their money versus a computer or a guy who is just following index weighting change instructions. People tend to invest more when they feel more comfortable with the person at the helm.
Passive Over Active Investing All Day
The vast majority of your equity and fixed income investments should be in passively run funds. Whether you want to allocate 51% or 100% of your equity and fixed income investments to passively-run funds, that’s up to you.
I personally shoot for ~80% passive and ~20% active investments because I still have an affinity to some of the clients I used to cover.
If you still love the idea of actively run funds, know that there is a level of active involvement in deciding what goes into a particular benchmark and its weighting. For example, variables such as market capitalization, profitability, float and liquidity, and geographic revenue composition play a factor in determining the S&P 500 index composition.
Further, if you insist on investing in active funds, you should look for categories that have less than 50% of the funds underperforming their respective benchmarks.
The main things you can do to grow your net worth through investing is minimizing fees, being objective about the performance data, investing consistently, and making sure you have a risk-appropriate asset allocation. Once you do those things, all you’ve got to do is wait and you will eventually grow rich.
Readers, what percentage of your investments are in active versus passive funds? Why do you think active investing is still such a huge industry? What else stands out about the data in equities and fixed income performance?
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