For decades, there has been a contentious debate around the use of active versus passive investment options. Historically, active managers, which I will define as those who pick individual stocks and bonds with the goal of beating the market, dominated the fund industry. This has changed over time, and a tidal wave of money has flowed into passive investment options, and for good reason. 

S&P Dow Jones (SPDJ) publishes a widely cited report at the middle and end of each year that evaluates the performance of active managers vs passive indices. The study is aptly called the ‘SPIVA,’ which stands for S&P Index vs Active. A couple of weeks ago, SPDJ published the mid-year 2024 SPIVA update. We have written about this study several times in the past as updated reports are published. While the period under examination changes, the conclusion drawn from the report has remained remarkably consistent. Most active managers fail to deliver.

The table below provides a summary of the findings. It separates active domestic mutual funds into categories based on their investment mandate, with the performance comparison based on various time horizons. The percentages illustrated represent the portion of active funds that failed to keep up with a relevant benchmark. As you can see in the column highlighted in red, the overwhelming majority of funds failed to beat the market over the long term.

Fund Underperformance Rates – Major U.S. Categories

Sources: S&P Dow Jones Indices LLC, CRSP. Data as of June 30, 2024. See Appendix for column definitions. Past performance is no guarantee of future results. Table is provided for illustrative purposes.

A few observations from the data:

• The average failure rate within the “Global Equities” grouping ranged from 81-88%.
• The failure rate for the “All Domestic Funds” category was 90%.
• Every fund in the “General Government” category failed to keep up with the benchmark index. Other bond categories did relatively well, but still saw a majority fail to keep up.

Unfortunately for investors, there was no way to know in advance which of the funds would wind up in the small subset of winners. Furthermore, there is no guarantee that any of the few outperforming funds can repeat that success over the next 10 years.

There are a variety of reasons active stock pickers tend to deliver poor results. First, the markets are pretty efficient. Asset prices reflect the collective knowledge of all participants. That doesn’t mean prices are always correct, but it does represent the best guess of fair value at any given point in time. To consistently outperform the market, you must consistently have an estimate of fair value that is more accurate than the collective wisdom of all other investors. Second, active managers tend to charge higher fees. This raises the hurdle that must be cleared to deliver superior results.

None of this is to say that investment professionals cannot be leveraged to help people reach their financial goals. Designing an appropriate asset allocation, the mix between riskier equity and more stable fixed-income investments, is a critical role that can deliver immense value. The behavioral component is also vital. A financial advisor can help keep emotions at bay, allowing clients to stay the course while other investors become overly optimistic or pessimistic.

Lastly, while market efficiency generally renders active stock-picking useless, there are ways to use the information held in market prices to enhance returns. Decades of empirical research have identified certain stock characteristics that are readily observable in current prices and associated with higher expected returns. These include low price (value), low market capitalization (size), and strong earnings (profitability). Tilting a diversified portfolio toward these characteristics is a way to improve returns without the high cost and guesswork associated with active stock picking.

Source: MarketWatch

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