A forensic examination of active managers

A forensic examination of active managers

Three new studies were published this month by Standard & Poor’s, Lipper and Morningstar on the performance of active funds versus their benchmarks.

They are not the first studies to have found that in most categories the majority of active managers are consistently lagging their benchmark.

In the first article for this column, we discussed how the move to indexing by many investors was, in part, driven by the challenge to find active funds that consistently beat their benchmarks. To support this view, we referenced some historic studies on the performance of active funds versus benchmarks. 

A number of people commented that they have never seen the studies and questioned the validity of their findings, namely, that most active funds do not consistently beat their benchmarks in the current market environment.

Demonstrable failure

The Lipper study looked at how well actively managed mutual funds in Europe performed over the past 20 years. It found that 26.7% of equity funds beat their benchmark in 2011, 40% over three years and 34.9% over the past 10 years. In 2011 only 23.7% of active bond funds beat their benchmark, 45.4% over three years and 16.2% over 10 years.

There are considerable variations among funds that invest in different regions. For example, UK and European equities have performed better than global mandates, while North American funds are those that have most consistently failed to beat their benchmarks.

Lipper estimates the active equity fund market in Europe is about €1.5 trillion, while index funds and ETFs account for €299 billion or 17% of overall equity assets.

Finding the time and information to select active funds in Europe is made more challenging by the large number of funds to select from – currently about 35,000. On average, some 3,400 new funds are launched every year and 2,400 closed.

Morningstar research analysed more than 1,300 long-only international equity funds in Europe, with at least 10 years of history. The study found an average of 6.8% of these outperformed their underlying benchmark – the MSCI World index.  

The tenth annual S&P indices versus active funds (SPIVA) scorecard found that over a five-year period the majority of active equity and bond managers in most categories lag their benchmarks. In 2011, 81% of active large cap managers underperformed the S&P 500. Changing the time horizon, or the asset class, makes little difference to the results.

Arguments refuted

The study refutes many of the theories on why and when to be active versus passive. Many investors feel small cap stocks are less efficient and should be actively managed and large cap stocks are more efficient and should therefore be passively managed. The study shows that indexing works as well for small cap as for large cap exposure.

Another theory posits that in bear markets active funds should be able to perform better than the index because they can move into cash and defensive positions. The SPIVA study identified two bear markets during the past 10 years and found most active funds failed to beat their benchmarks. 

In Europe, typically four out of 10 active funds beat their benchmarks. The challenge for the retail investor is whether they have the skill, time and information to select the right funds.

It has been a consistent theme of this column that the investor, particularly the retail investor buying on an execution-only basis, needs to understand the nature of what he is buying. For as long as this debate of active versus passive continues the retail investor may decide that it is best to use index funds or ETFs for some of the exposures they desire.