10/16/2017 – Because it probably won’t happen. Is it at least possible for you (or your fund) to beat the index? Of course it is, but it depends on which market you are playing in, your access to key information, your skill, and your luck. But in the end, the odds are simply stacked against you.
One of my favorite reports to read is the SPIVA U.S. Scorecard. SPIVA (S&P Indices Versus Active) publishes statistics about the performance of active funds versus the performance of their benchmarks. For those that do not know, the active versus passive debate has been going on for decades. The debate boils down to one factor: does the fund manager (active manager) believe he/she can outperform the fund’s underlying index?
The answer is that passive management easily beats active management in just about every U.S. category.
The most important line item is the Large Cap category, which is the most popular and the most influential. 56.56% of funds were out performed by the S&P 500. Or a better way to phrase it, only 43.44% of funds outperformed the benchmark.
It gets worse as you increase the time horizon. Only 18.15% beat over the previous 3 years. And only 6.82% beat over the previous 15 years. In other words, if you were to invest in a random active mutual fund 15 years ago, you would only have a 6.82% chance of that fund outperforming the index.
FYI – S&P does a great job to ensure that this data is as realistic and correct as possible. They correct for survivorship bias, style consistency, asset-weighted returns, etc.
International Markets A Little Better
Other countries are not nearly as efficient as the U.S., giving managers a better chance of outperforming. Still, the odds are not in their favor.
What About Past Performance?
Most investors look at a manager’s past performance when determining whether or not invest. One of the most important measurements is whether or not the manager can deliver above-average returns over multiple periods. However, outperforming over time has also proven to be difficult.
“An inverse relationship generally exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that less than 1% of large-cap funds and no mid-cap or small-cap funds managed to remain in the top quartile at the end of the five-year measurement period. This figure paints a negative picture regarding the lack of long-term persistence in mutual fund returns.” (S&P Persistence)
As many of you know, Bull Oak Capital only invests in passive index ETFs because of this data. The odds of outperformance at the sub-asset class level is low. So why play the game? Many managers will argue that they are able to exploit inefficiencies in the market and capture that value (alpha). Perhaps they can, but most cannot. For those that have, I have a few questions:
- Can you recreate your methodology and be able to capture that value year-over-year in a consistent manner? FYI – Managers that have proven to do this are household names and billionaires.
- How much of that outperformance (if any) is due to skill versus luck? Are you simply riding momentum or are you style drifting?
- How much of your outperformance is due to luck?
The truth is that most individuals can’t tell whether or not a fund manager is skillful or lucky. Persistence is one important measure to test this, but not the only one. Better to not play the game at all in an effort to keep your pocketbook and sanity levels high.
Bull Oak Capital
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