You have to feel sorry for active managers.
The first actively managed mutual fund was introduced in 1924. More than 50 years later, in 1976, John Bogle introduced the first publicly available index fund. Despite their huge head start, actively managed U.S. equity funds now manage less in assets than passively managed funds. They were overtaken by the passive funds in 2018, according to Bloomberg.
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In 2021, passively managed U.S. equity funds added $346 billion in new assets, while actively managed funds had $195 billion in outflows, according to Morningstar.1 In fact, since 2006 actively managed U.S. equity funds have lost assets every year (except for a slight gain 2013), while passively managed funds have experienced significant positive inflows.
This trend may be due, in part, to another problem active managers have. They have a hard time beating relevant benchmarks. Most can’t beat them for even a single year and, of those that do, few continue their winning ways for long.
According to the year-end 2021 SPIVA Scorecard research from S&P Dow Jones, here is the percentage of actively managed U.S. equity funds that underperformed the S&P 1500 Index over various time periods ending December 31, 2021. It paints a grim picture.
- 72% for the three-year period (80% on a risk-adjusted basis)
- 75% for the five-year period (81% on a risk-adjusted basis)
- 86% for the ten-year period (93% on a risk-adjusted basis)
- 90% for the twenty-year period (95% on a risk-adjusted basis)
S&P Dow Jones research has made similar findings for every type of actively managed fund compared to its relevant benchmark, year in and year out.
Not only is their performance lackluster, but the survival rate for active managers is woeful. S&P Dow Jones found that over the past 20 years, nearly 70% of domestic equity funds have been merged or liquidated out of existence.
Why is active management so hard?
Active U.S. equity fund managers have clearly taken a beating relative to their passive counterparts and relevant benchmarks. But the problem is not limited to active U.S. equity fund managers. Institutional managers, fixed income fund managers, tactical allocators, and market timers have similar problems. See one of my previous articles, Don’t Believe the Rules in Investing.
With so many brilliant people devoting their careers to active management, why are their results so disappointing? Here are 10 reasons:
- Active management Is not a science. Water freezes at 32 degrees Fahrenheit. Light travels at 186,000 miles per second. The Earth travels around the Sun once every 365 days, 5 hours, 59 minutes, and 16 seconds.
There are no equivalents in investing.
We can measure how markets have behaved in the past, but there are no rules of the universe dictating that they will repeat their behavior. The past can serve as a guide and help us set the boundaries of our expectations, but we cannot rely on it to repeat itself.
- Markets are complex adaptive systems. Financial markets are comprised of millions of heterogeneous participants who may apply different decision rules to their activities. The market’s behavior is the sum of their activities.
The goal of each participant is, ultimately, to extract economic value from the market at the expense of other participants. To do this, they must learn and adapt. Thus, the size and shape of the playing field, and even the rules of the game, are always changing.
- Value Is in the eye of the beholder. It is common to hear an active manager talk about whether markets or stocks are over- or under-valued. This implies that there is a “normal” or “correct” value, and that the manager knows what it is.
Active managers investing based on this frame of reference will be sorry. For the last 50 years (1972-2021) the average trailing 12-month P/E ratio of the S&P 500 Index was 19.66. On average, investors were willing to pay $19.66 per share for $1 of earnings.
During that period, the S&P’s P/E ranged from 7.39 in 1980 to 70.91 in 2009. Obviously, the market’s perception of value changes over time. There is no rigid, mechanical way to determine the “normal” or “correct” value. This makes active management difficult. How do you anticipate how millions of market participants will perceive future value?
- There are many well-armed competitors. Despite the move toward passive investing in recent years, there are still many talented professionals trying to extract value from the financial markets. As Charles Ellis observed: “They have more advanced training than their predecessors, better analytical tools, and faster access to more information.”
These well-armed competitors make the markets even more efficient and make it even harder for an active manager to gain an advantage.
- Not every good idea turns out to be a good investment. Active managers make bets. The bets may be company specific or more macro, like a bet on a sector, a factor, or an investment style. The bets are usually driven by research, experience, and judgement.
There are always forces at work that turn even the most well thought through bet into an empty intellectual exercise. They might be company specific, like a new competitor or an emerging technology. They might be more global, like a war, a pandemic, or a housing bubble. The most powerful of all is systemic market risk. Even the best ideas may struggle to take root during a market downdraft.
There are always more variables than can be reasonably considered. The future is unknowable. Active managers are always playing the odds. Not every bet pays off.
Read the full article here by Scott MacKillop, Advisor Perspectives.
