Active managers versus the benchmarks. Spoiler alert: the managers lose (again).

by Paul Meloan

In what has become a maddeningly predictable outcome, the current report card on active U.S. mutual fund managers was released by S&P.

Virtually since the SPIVA report card was created, active mutual fund management has enjoyed a track record reminiscent of the Chicago Cubs.  Sometimes they flirt with mediocrity, but ultimately they come up a run (sometimes many more) short.

Begin with a simple premise, articulated by Nobel prize winner Bill Sharpe, Vanguard co-founder John Bogle, and others who have devoted their professional lives to understanding how markets work: the total return of all investors (emphasis mine) must equal the return of the market, minus all the costs of investment.  This is not differential calculus, it is arithmetic.  Compared to the market average, if someone did better, that means someone else did worse.  This is not Lake Wobegon: in the aggregate, we are all precisely average.

Active fund managers stand that premise on its head.  They think, “We are good enough, smart enough, and dog-gone-it we are going to do better than average.  And you, the investor, who does not possess our unique abilities and experiences, cannot possibly equal our performance.”  Were that it were true. 

Some highlights from the current report card:

More than three out of five large cap funds (those that invest in the biggest U.S. companies) could not beat the S&P500 over the last five years (61.28%). 

Managers of small cap funds believe those markets are less efficient, because small companies are not followed as much, and are traded less.  They are right on both counts, but it didn’t matter: small cap growth funds lost 75% of the time, while small cap core (59%) and small cap value funds (48%) did little better.  At least the small cap value funds can claim they beat a coin flip.

Another interesting thing is what happens to funds that fail to beat their benchmarks, or at least their peer-group averages: they get blowed up.  One-quarter of all active funds do not survive five years.  The funds are liquidated (they give the money back to their shareholders) or, more likely, they are merged into a better-performing fund owned by the same company.  Managers, after all, are in the business of raising money, not giving it back.  That’s how they get paid.  When that happens, their performance history of the laggard fund generally disappears.

So, when your fund company shows how many of their funds beat their averages, pay no attention to the pile of under-performing funds piled up out back.  After those get hauled away, the fund company will make a fresh pile in the next few years.