The Failure of Active Management

Percentage of Active Public Equity Funds That Failed to Beat the Index - Five Years as of December 2011

The debate over market efficiency and active versus passive management may never be settled. But no one can argue the historical returns evidence, which shows that active management does not pay for itself, in aggregate.

The efficient markets hypothesis implies that no active investor will consistently beat the market over long periods of time, except by chance. Yet active managers test the hypothesis every day through their efforts to pick stocks and time markets. The evidence shows that their efforts are not worth the high cost borne by investors.

This illustration displays the percentage of actively managed public equity funds that failed to outperform their respective market benchmarks for each major fund category for the five-year period ending December 2011. Most of the fund categories failed to beat their respective benchmark as a group. This is consistent with research, which shows that, as a group, active managers underperform the market by an amount equivalent to their average fees and expenses.

The lone exception is the international small fund manager category during the period. As indicated in the graph, 26% of this group failed to beat the respective benchmark, which is the S&P Developed ex-US Small Cap index. More detailed analysis reveals that many managers in the international small category had significant holdings in emerging market stocks, which is a different asset class that had stronger performance during the period. The large percentage of out-performance among international small managers may result from a large portion of them holding a different asset class and being compared to the wrong benchmark.

If the manager group’s average return is benchmarked to an international small cap index that includes emerging markets, the rate of underperformance rises to over 60%, which is in line with the other equity fund categories. (Benchmark is the MSCI All Country World ex USA Small Cap Index.)

Percentage of Active Public Fixed Income Funds That Failed to Beat the Index - Five Years as of December 2011

Research by Eugene Fama and other financial academics has offered evidence that the bond markets are efficient and that interest rates and bond prices do not move predictably. This appears to be the case with all types of issues, from short-term government instruments to long-term corporate bonds.

This illustration demonstrates the formidable challenge that active bond managers face. The graph shows the percentage of active fixed income funds in each category that failed to beat their respective market benchmark for the five-year period ending December 2011. All categories had at least a 61% failure rate, with failure defined as underperforming their benchmark.

This is consistent with financial theory and research, which propose that active managers cannot outperform the market as a group, particularly after accounting for management fees, trading costs, and other expenses.

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Source: Standard & Poor’s Indices Versus Active Funds Scorecard, year-end 2011. Index used for comparison: US Large Cap—S&P 500 Index; US Mid Cap—S&P MidCap 400 Index; US Small Cap—S&P SmallCap 600 Index; Global Funds—S&P Global 1200 Index; International—S&P 700 Index; International Small—S&P World ex. US SmallCap Index; Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database.

Source: Standard & Poor’s Indices Versus Active Funds Scorecard, year-end 2011. Index used for comparison: Government Long—Barclays Capital US Long Government Index; Government Intermediate—Barclays Capital US Intermediate Government Index; Government Short—Barclays Capital US 1-3 Year Government Index; Investment Grade Long—Barclays Capital US Long Government/Credit; Investment Grade Intermediate—Barclays Capital US Intermediate Government/Credit; Investment Grade Short—Barclays Capital US 1-3 Year Government/Credit; National Muni—S&P National AMT-Free Municipal Bond Index; CA Muni—S&P California AMT-Free Municipal Bond Index. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Barclays Capital data, formerly Lehman Brothers, provided by Barclays Bank PLC.