As a Whole, Actively-Managed Funds Underperform
When actively-managed funds are sold to investors, what is also sold is the expectation that through superior research and management, active mutual funds will outperform their passive benchmarks, in spite of the fee differential. But in aggregate, this is not true. In fact, across asset groups and time periods, average actively-managed funds underperform passively-managed funds. And on average, the funds that have the highest total expenses tend to underperform their less expensive actively-managed funds as well as index funds.
In a book I wrote several years ago, I highlighted the massive underperformance mutual investors have achieved, on average, over very long period of time. There are two primary components to investor underperformance. First, is the tendency for investors to buy “hot” stocks, sectors or into expensive stock markets, and shun those same areas or markets when they are out of favor. Unfortunately, investors and advisors often chase hot funds or hot sectors, right before there is a turnaround, and those outperformers become underperformers. And the longer such trends persist the more likely investors are to put money into those areas (an increasing expectation that recent past performance will continue into the future). In other words, as a whole, investors buy high and sell low. Secondly, for fund investors, underperformance is also due to the higher costs and related underperformance of the (actively-managed) funds themselves. The combination of these two factors have contributed to many decades of consistent general underperformance among individual investors.
In the 30-year period of 1945 to 1975, John Bogle looked at the performance of stock mutual funds then existing. He found that the average equity (stock) mutual fund earned an average of 8.7% per year, while the S&P 500 index earned an average of 10.1% per year. Not coincidentally, that underperformance of 1.4% per year is roughly in line with the higher fees for the actively-managed funds compared to the market. (Index, or passively-managed funds have fees too, of course, but generally are substantially lower than those of active funds).
When it comes to mutual fund investing, in general, you don’t get better performance by paying more. Just the opposite. Morningstar data from the 5-year period of 2005-2009 showed that for each of the five major fund asset types – U.S. stocks, International stocks, “Balanced” funds, Taxable bonds, and Municipal bonds – the funds in the highest quintile in terms of cost had the lowest returns, and those with the lowest costs had the highest performance. For each of the five categories, the underperformance of the expensive funds was about 1.0%-1.5% per year, roughly in line with cost differences between funds.
(While average management fees has generally declined over the last several decades for both index funds and actively-managed funds, the gap between the two is still significant, currently in the area of 0.8% per year for equity mutual funds and 0.6% per year for bond funds. Added to this too, is the more hidden part of fund expenses, trading expenses, which although they’ve also declined, are also larger for actively-managed funds.)
A similar ten-year study (1994-2004) from Standard and Poor’s found that the average expense ratio difference between high-cost and low-cost funds was about 1.0% per year, but the underperformance of the more expensive funds averaged about 1.8% per year. (This is likely explained in part by higher trading costs, and the higher turnover (trading) of more active funds.) And this underperformance was found in eight of the nine asset sectors (large-company growth, small-company value, international, etc.) analyzed over the period (with a miniscule 0.01% outperformance among mid-cap growth companies over the period).
The combined effect of investor performance-chasing and overall actively-managed fund underperformance results in a shocking disparity between average market indexes and average returns earned by investors. Below I’ve reprinted a graph from data I included in my book Let Your Money Grow (slightly edited).
Performance chasers turn to index funds
Now, however, the pendulum has shifted. Whereas a substantial segment of investors (and advisors) in the past, looked to actively-managed funds to outperform the market, now a substantial sector of the investing public has turned to index funds as today’s hot performers. But this has less to do with understanding the long-term effects of higher costs on fund performance than simply because in recent years index funds have “had the hot hand”.
As the graph below shows, over the last several years, index fund outperformance (active fund underperformance) has accelerated. We are currently in a period where the percentage of active funds beating the market over the previous five years has fallen to barely 10%. But we also see that there are historical periods in which a majority of actively-managed funds have beaten the market. In general, actively-managed funds do better during times of market volatility or after a sharp market correction. It is during those times that investors are rewarded by the ability of active managers to be less than fully invested or to pull back from areas of the market that look expensive. Conversely, index funds tend to do well after long Bull Markets, benefitting from lower costs, less volatility or opportunities to outdo the market, and increasing concentration in indexes of popular (and rising) stocks (such as Nifty Fifty stocks, tech and dot-com stocks, from past bubbles and the FANGS of today).
In the graph below from The Wall Street Journal, we see that looking at U.S. large-company mutual funds (the most popular category of mutual fund for U.S. investors) actively-managed mutual funds, about 37% of large-cap active funds beat the index over the ten years ending mid-2016. Actually, that’s not bad considering the higher expenses from actively managed funds.
So the question is, why would the percentage of actively funds beating the market fall at all, let alone, so dramatically from the 10-year horizon to shorter 1,3 and 5-year period, when, statistics tell us there should have been an increase in outperformers? The underperformance of actively-managed large-cap funds is especially shocking at these shorter periods, such as 1 and 3 years. Clearly, the relatively small difference in fees over a year, or even three years, cannot account for such underperformance among actively-managed funds.
What is different in the stock market over the more recent past compared to the last decade is the difference in volatility. During the last five years there has been almost none in the market, while the last ten years included the 2008-2009 decline where the S&P 500 dropped by half, before reversing course and resuming its upward trend. During the market decline (during the 10-year period) actively-managed funds as a whole would have held more cash on the sidelines compared to index funds, as well as more opportunities to raise more cash as a crash looked likely (or began). Index funds by definition are nearly always full invested, and just go along for the ride, up or down.
In contrast, over the past several years, there has been so little volatility in the stock market, historically speaking, that it gives very little opportunity for active managers to outperform on superior timing, buying and selling into under or overvalued markets. With the more managed markets of the last several years, markets now steadily rise with hardly a pullback.
Unfortunately too, index funds, despite their many benefits, have an Achilles heel in the way that popular stocks take on an increasing weighting within funds, perpetuating overvaluation and overconcentration among increasingly risky stocks. During periods of overall stock market overvaluation, outperforming stocks and sectors take on an increasing concentration within index funds.
Those same overvalued areas and stocks then become even more overvalued as more money comes into index funds and by design must be invested into the most overvalued areas or stocks, further distorting the market. At that point, while individual or fund managers buy stocks because they appear to be attractive investments, more money into index funds ignores screening and analysis, but simply buys them because they’re in the index. This is a risky situation in expensive markets and why there is often a quick reversal of index outperformance once markets take a downturn, and the most expensive areas and stocks are hit especially hard.
Is history repeating itself once again? Will today’s flocking into index funds (as investors did at the end of past Bull Markets) lead to more long-term underperformance among individual investors? Time will tell, of course, but investors who believe that index funds are the “safer” choice today, because they have been the better performers for the last several years, may be setting themselves up for disappointment. There is no doubt that many investors are “overactive” in the market, buying and selling, especially during periods of high market volatility. But today, with the last few years of extremely low volatility, investors who are simply “owning” the market, via index funds, are also taking a risk, of not being a little more active. And today might be one of those unusual times when it might be worth it to pay a bit more for good active management, for managers who are watching out for tomorrow’s risks.