Index Investing vs. Active Fund Managers

Every 6 month’s Standard & Poor’s releases an update of how active mutual fund managers perform against their benchmark index.  This report is called the S&P Indices vs. Active funds (SPIVA) scorecard, and can be found here.  It’s an independent study that serves to act as a scorecard for the ongoing debate over which style of investing is better – using Index Funds or Active Fund Managers?  The scorecard also includes some other helpful information like “style-drift” for any investors or advisors employing a style-box approach to diversification.

This is something I like to check every year, mainly because I find it interesting.  The scorecard shows that over time the majority of active fund managers fail to beat their benchmark index – a key reason why I heavily use individual securities and ETF’s for my clients.

They released the mid-year 2012 numbers a little over a week ago and the results remain consistent.  The report breaks things down into quite a bit of detail, including growth, value and blend, but here are the general number of actively managed funds that failed to beat their benchmark over the last 1, 3 and 5 year periods:

Over the last 5 years, the only equity fund category that active managers have been able to outperform the benchmark is International Small Caps at 75% outperforming.

It’s arguable as to why the majority of actively managed funds tend to underperform, but I like to boil it down to two things.

First, a fund manager’s primary goal is to beat its benchmark.  If a fund under-performs though, not only can the fund lose investors, but the manager might lose his/her job!  This fear of falling short by a few percent puts a lot of pressure on the manager to invest very closely to the index (let’s say with 80% of the fund) and then overweight their favorite picks to hopefully outperform.  This “overlap” tendency by managers has been well documented over the years.

The second reason is expenses.  If you’re investing with a lot of overlap with your benchmark (for fear of missing dramatically and losing your job), it’s now going to be pretty difficult to make up your fund’s annual expense ratio (not to mention the additional drag on performance from turnover, etc.).  With most actively managed funds running an annual expense ratio of 1% or more, they now have to outperform the benchmark by at least 2% per year!  Easier said than done…

To me, it’s clear that a portfolio should not be heavily invested in actively managed mutual funds.  Not only are they costly and tax-inefficient, but managers tend to have the wrong incentives for the everyday investor.  The majority of people I work with are investing for specific goals – things like retirement, their children’s education, weddings, etc.  An investment plan should be built to achieve these goals with as little risk as possible, not to outperform an index.

-Nick