Blog #61 The Law of Active Fund Management

I like mutual funds (unit trusts, as they called in Singapore). I like them not because most are great performers, nor because they offer affordable diversification, but because we know what mutual fund managers do everyday. Broadly speaking, they manage their portfolios actively, as opposed to an exchange traded fund (ETF) which is essentially passive. Not only that, we also know that mutual funds are expected to be almost fully invested at all times because investors don’t pay mutual fund managers to hoard cash. Combining these two facts, we have a good picture of what mutual funds do – they spend most of their time picking securities such as stocks (equities funds), bonds (income funds) or both (balanced funds). To be brief, I will focus on equities funds for the rest of this blog.

Stock picking isn’t at all easy (see my previous blog). But since fund managers are supposed to be ‘experts’ in this area, mutual fund investors naturally have high hopes that this expertise will translate to returns that are superior to those obtained from ETFs. To use the jargon, investors expect to alphas. Sadly, most investors end up disappointed.

Since 2002, Standard & Poor’s Dow Jones Indices LLC, a division of the S&P Global has been tracking the relative performance of equity and bond mutual funds in the US and other markets such as Australia, Canada, Europe, India, Japan, Latin America, South Africa. I will focus on US funds since America has the lion’s share of global mutual funds by numbers and assets under management. Also, the performance patterns of non-U.S. funds are broadly similar to those in the US.

S&P summarizes the relative performance of different types of equity funds using what they call a SPIVA Scorecard (SPIVA stands for S&P Inactive versus Active). The SPIVA Scorecard compares the net-of-fees returns of actively managed mutual funds against their appropriate benchmarks on a semiannual basis (a report is produced each mid-year and at year-end). For example, the year-end 2016 Scorecard reports the percentage of funds in a specific category that either outperforms or underperforms their respective benchmarks over a 15-year period. Results for shorter periods of 1, 3, 5, and 10 years are also reported.

Because market conditions can impact managers’ performance from year to year, it makes more sense to look at longer-term returns. Hence, I will focus on rolling 3-year relative performance instead of yearly numbers. All the data are extracted from the 2016 SPIVA US Scorecard report which is freely available from S&P’s website. The raw data for compiling the US SPIVA Scorecard comes form the Chicago Research for Securities Prices (CRSP) US Mutual Funds Database. This is a comprehensive database containing data on more than 10,000 US mutual funds. Importantly, it is free of survivorship bias.

 

Let’s now zoom in on the main question: do most equity funds beat the index? A “yes” would inspire confidence about active fund management. A “no” suggests that true stock selection skills are in short supply in the mutual funds industry.

There is a lot of data to look at, enough to give you a migraine. To minimize this risk, I will present graphics rather than numbers.Let’s start with the following chart showing the relative performance of “domestic funds”, those that invest solely in US stocks.

SPIVA1.jpg

What story would you like this graph to tell? What do you think is an appropriate caption for this chart?

Answer to the caption question: The percentage of domestic equity funds beaten by the benchmark index based on rolling 3-year returns.

The chart shows that in most years from 2002 through 2016, the index has outperformed active funds, not the other way around since the performance line is generally above the 50% mar. Making things worse, this line has risen ominously over the years indicating that relatively more and more domestic funds have trailed the index!  For the full 15-year period, a whopping 82% of domestic fund managers have been “underwater” so to speak.

Before I go on, spend a minute to reflect on what this evidence means to you as an investor.

Let’s proceed to look at other equity styles. The next six charts show the relative performance of large-cap versus mid-cap funds. Each of these categories are in turn subdivided into growth funds, value funds and those which are neutral to these styles (core). SPIVA2.jpg

Again, the basic story is the same. Years in which the market beat funds outnumber years in which funds beat the market (by ‘market’ I mean the relevant benchmark index). Many investors gravitate towards styles like “growth” or “value”. The evidence shows that investors are generally better off sending their cheques to a growth or value ETF than to a mutual fund. This is not to say that investors don’t get lucky with mutual funds. But unlike true skills which is consistent, luck is not. What the evidence says is that the odds of a mutual fund investor outperforming the index on a consistent basis is less than 50%, often much less.

Stanford economist, William Sharpe, achieved fame for developing the Capital Asset Pricing Model or CAPM. He also wrote a highly interesting article with the title “The Arithmetic of Active Management” (Financial Analysts’ Journal 1991). Below is a summary of the gist of that article:

Sharpe.jpg

Sharpe’s logic is presented as an equation (above) based on a simple but powerful logic. An investor is either passive or active. Hence, the market is collectively made up of passive and active investors. Passive investors buy index funds and achieve market-like returns both before and after fees (this is due to their low fees). For the equation to add up, active investors as a group must also earn market-like returns before active fees. The punchline is that after fees, their net returns will be inferior to those of passive investors. This is true at all times and for all investment styles. Putting it bluntly, Sharpe’s “law” of active fund management implies that the average active investor is doomed to fail or lag behind the index. As shown earlier, mutual funds provide exactly the kind of evidence that confirm Sharpe’s logic.

Please understand that while Sharpe’s law is mathematically true, it does not offer deeper explanations why passive investment outperform active investment.  The high fees that mutual funds charge is certainly one reason. Perhaps the average fund manager isn’t smart enough in picking the right stocks or if he did, lacked the holding power to realize their full potential (again, refer to Blog #60). Or the mutual fund manager was basically hugging a market-like portfolio (heavens forbid), and hence is not deviating enough from the index to make a difference to the fund’s returns. Whatever the case, the data strongly supports Sharpe’s observations. That is enough to sway me towards passive investing.

Let me conclude by showing a few more charts. The following three charts show mutual funds that target small firms. Like their large-cap counterparts, these funds are also not beating their respective benchmarks. In all cases, the relative performance line is well above the 50% mark for most years.

SPIVA3.jpg

How about funds with a more international focus?  On the left, we have global equity funds, and on the right, emerging market funds. Same story. I rest my case.

SPIVA4

 

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2 thoughts on “Blog #61 The Law of Active Fund Management

  1. Hi, Nice article for a new investor to read on. So do you mean unit trusts by banks or those offered by Fundsupermart generally do not provide better returns for retail investor VS an ETF? Thank you.

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    1. Hello. I cannot comment specifically on local unit trusts because it is hard to get detailed performance data compared to the US but logically, I don’t see any reason why performance-wise, Singapore fund managers should be systematically different from US fund managers. If anything, it’s likely to be worse since average expense ratios here are significantly higher than those in the US.

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