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Worth Considering: The latest scoring by S&P Dow Jones on active fund managers

wc_peartreeThe latest SPIVA report by S&P Dow Jones offers a mix of old and new news about the performance of active investment managers. What’s new is that their scoring of performance for the first time extends over 15 years, a much longer time period over which to assess the performance of active managers. The old news is that the overwhelming majority of active managers struggle to match or outperform their market benchmarks.

Since 2003, the SPIVA report (S&P Indices versus Active) has been the de facto scorekeeper in the debate over active versus index investing. The longer time horizon reported in the latest report is helpful because it overcomes the objection to earlier reports covering one-, three- and five-year periods that they fail to capture full market cycles.

Better performance by active investment managers is always promised to be just around the bend and, indeed, some years are better than others for active managers. In 2007, for example, nearly 56% of U.S. large cap stock managers outperformed the S&P 500. Several years later however, in 2011, 82% of those managers underperformed the S&P 500.

Results vary from year to year. There is enough variability in the performance of active fund managers from year to year to continually hold out the promise that the next year’s performance will be better. Long-term performance data tells a different story. Over longer periods the results are consistently poor for active managers as a group. Over three-, five-, 10- and 15-year periods the percentage of US large cap stock funds underperforming the S&P 500 has ranged from 84% to 93%.

Investors are perhaps accustomed to hearing about difficulty funds have matching or beating the S&P 500, the most widely followed U.S. stock benchmark, but what about other areas of the market? A common argument raised in support of active management is that while it has become more difficult for managers to assemble a portfolio of large company U.S. stocks that outperforms the S&P 500, managers stand a better chance in less efficient markets like small cap stocks. If only it were so.

The latest SPIVA report shows that in every single category of U.S. equity funds measured, 18 in all, most funds underperformed their benchmark over a 15-year period ending December 2016. Not only were there no exceptions, the percentages of underperforming funds was shockingly high — ranging from 78% underperforming funds in the large cap value category to 99% of small cap growth funds.

The same pattern is evident with bond funds. Across all 14 bond categories examined over 15 years, including government, investment grade, high yield, global, and tax-exempt, most funds underperformed their market benchmark. The percentages of underperforming funds ranged from a low of 69% in the global income category to a high of 97% in the long-term investment grade category. Of special interest to New York residents, 90% of NY tax-exempt funds underperformed their benchmark over 15 years.

The highly respected Rekenthaler Report issued by Morningstar noted that “(a)cross the board, in every category that the SPIVA paper examined, the benchmark triumphed for the 15-year period. No exceptions.” That’s more than 36 fund categories in all. Even in the supposedly inefficient corners of the stock markets, like emerging markets, the results were much the same. Eighty-nine percent of emerging market funds underperformed their assigned benchmark.

One major caveat to the SPIVA report is that it does not examine the impact of fund expenses on performance. Morningstar does, however, and reaches some interesting conclusions. Morningstar issues an annual report similar to the SPIVA report called the “Morningstar Active/Passive Barometer.” The Morningstar report uses a slightly different methodology but reaches very similar conclusions about the inability of most active fund managers to match or beat their benchmarks.

The Morningstar report, however, finds that sorting funds by their expense ratios helps to identify better-performing funds. In the most recent Morningstar report issued April 2016, a much higher percentage of funds in the lowest expense quartile matched or beat their benchmark than did funds in the highest expense quartile.

In the 12 fund categories that Morningstar examined, selecting funds with expense ratios in the lowest 25% significantly improved the odds of success against their benchmark. The results, however, are still underwhelming. In most cases, even the lowest expense funds still underperformed their benchmark.

For example, among large-value U.S. stocks, only 22% of funds in the highest cost quartile beat their benchmark while 48% of funds in the lowest cost quartile did. That is a significant improvement but still underwhelming.

Only in three categories — emerging market funds, mid-cap value stocks and intermediate-term bonds — did the lowest cost quartile of funds beat their benchmarks, and even then the percentage of winning funds was not very high, only 61%, 53% and 51% respectively. Sorting funds by cost helps but not enough by itself to make a material difference.

An optimistic investor could look at the data and conclude that roughly 10% to 20% of fund managers can beat their market benchmarks over 15 years. A more realistic investor might conclude that the odds of assembling a market-beating portfolio of funds remain so low that it’s not a smart bet to make. The more probable path to investment success is to capture market-like returns at an efficient cost using index or market tracking funds.