Active vs. Passive: The View from Standard & Poors

“The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”

-Standard & Poors Indices versus Active Funds (SPIVA ®) Scorecard¹

S&P recently published its eagerly awaited year-end 2011 scorecard, and the story for actively managed funds continues to remain dismal, as seen in the table below.

The true numbers are actually worse because the returns evaluated by S&P are not adjusted for loads.Since its ultimate source of data is the Mutual Fund Database from the Center for Research in Security Prices, SPIVA accurately accounts for funds that failed to survive the period due to merger or liquidation. The well-known commercially-used fund databases suffer from this survivorship bias which causes active managers as a group to appear to have better returns than is actually the case. Another helpful aspect of SPIVA is its tracking of style consistency among active funds. For the five years ending 12/31/2011, only 49.3% of all active domestic equity funds both survived the period and maintained the same style. For investors who are concerned with maintaining a consistent asset allocation, actively managed funds are poor vehicles.

At this point, we will review some of the myths that are busted by SPIVA.

Myth: Indexing is fine for large-caps, but since the small-cap market is inefficient, an active manager can take advantage of those inefficiencies and thus outperform a small cap index.

Fact: “Over the last decade, SPIVA has consistently shown that indexing works as well for U.S. small-caps as it does for U.S. large-caps.” The table below provides the numbers.

Myth: Active managers do better in bear markets than index funds because they can make defensive moves while the index funds are forced to ride the market down.

Fact: “In the two true bear markets the SPIVA scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.” The table below provides the numbers.

Of course, a naïve reader of SPIVA could argue that it does not apply to him because he will find the rare manager who can consistently outperform his peer group. SPIVA’s companion report, The S&P Persistence Scorecard belies this claim. It shows that year after year, the number of managers who remain in the top half of their peer group is either equal to or less than 50% (what we would expect from chance). Even if an investor thinks he has found a manager who has outperformed his benchmark over a long period, a statistical test such as the t-test will often show that luck cannot be ruled out as the explanation. To summarize, would-be manager-pickers would do well to read the SPIVA report along with the S&P Persistence Scorecard and take their lessons to heart.

¹http://www.standardandpoors.com/indices/spiva/en/us