August 31, 2014

Active Management vs. Passive Management: Does Stock Picking or Indexing Reign Supreme?

Ah, the age-old question: Which is better? Active or passive management?

Lately, the lines have become blurred between what exactly qualifies as active management. Most people would probably agree that funds tied to the most popular indexes, like the S&P 500 or Russell 2000, fall squarely into the passive category. The proliferation of alternative indexes, including those that "smart beta" ETFs are based on, confuses the issue. Is it active or passive management when you base a fund on a set of strict screening or filtering rules, but those criteria include metrics like, "rising sales, earnings, book value, dividends or cash flows?" Basing an index on rules that look nice when back-tested might appear to some to be just as active as a a stock-picking fund manager. So given that it's not always clear what ETFs or funds fall into each category, let's consider:
  1. According to ETFdb, the 35 equity ETFs that fall into the "active" category have an average expense ratio of 0.89%. That's a pretty huge hurdle to overcome for active management when there are 30 passive ETFs that have an expense ratio of 0.10% or less. Investors have to ask themselves if paying upward of 9X in expenses is worth any potential upside from active management. Would you be confident any particular active fund could consistently beat indexing by more than 0.80% each year?
  2. A look at the TradeKing mutual fund screener results in 4,892 equity mutual funds. The subset of that with expense ratios of 2% or higher is 1,000 funds! I took at look at 5 active mutual funds with expense ratios of 2% or higher, with over $1 billion in next assets. Over the past two-and-a-half years, the SPY S&P 500 ETF outperformed 4 of the 5 expensive active funds (a couple to the tune of around 30%). Only one beat the passive indexing approach, and by only 5% during that time. Picking active funds is like stock picking: are you confident you can pick the ones that will beat the market over the long-term?
  3. Some active funds in my company's 401(k) look like great performers over the past 10 years+. A closer examination of each reveals that there were usually 1-2 years of market outperformance that explain all of the long-term outperformance (often many years ago). Not to mention that many of the funds might be in the plan precisely for that reason. Funds with long-term underperformance were probably culled from the plan long ago - a kind of plan survivorship bias.
  4. Over a 20-year period going back from early 2014, the survivorship rate of actively managed funds was only 34% compared to the 55% rate for index fund share classes.
What else does the data show?
This awesome infographic from the L.A. Times shows that for the five years ending June 30, 2013:
  • 77% of actively managed U.S. large-cap stock mutual funds lagged their index during that time
  • 75% of actively managed U.S. mid-cap stock mutual funds lagged their index
  • That number was 64% for small-caps, 57% for emerging markets, and 56% for foreign large-caps
  • Only active intermediate-term bond funds did better during that time
  • Over 10 years, there was a benefit to indexing in all U.S. categories, including bonds
  • Average annual management expenses for active funds ranged from 0.59% to 1.00%
Dalmatians everywhere say active management has a spotty record at best!Perhaps even more telling: "Over 25 years the numbers are more striking. A $10,000 investment in the Vanguard 500 fund grew to $99,503, or nearly $24,000 more than the value of the average large-cap fund in that period." And according to Vanguard, over the course of the past 15 years, well in excess of 60% of actively-managed funds (included closed funds) underperform indexes across large, mid and small market cap categories (that figure is higher than 80% for intermediate-term bonds). Over 40 years, active management beats indexing just 12% of the time.

While there are some outliers, finding an active manager who can consistently beat the market appears to be just as difficult and picking individual stocks that can do the same. Just because a particular fund or security has had a great run for 5, 10, or even 15 years, there are no guarantees that will continue into the future. If anything the odds are against active management.

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