“A great year in the markets, but few managers beat their indexes”
“Their long-term record is even worse, according to a report on indexes versus active managers”
Source: InvestmentNews, 3/16/2018
Every year you can count on articles like this popping up like clockwork. The short version goes something like this: active managers for the most part, underperform their respective benchmarks or indexes. Typically, over the last one to three years, only 40% of active managers outperform the index. So, in conclusion, why would anyone pay higher fees for active management when they could just invest in the index and have higher returns over time?
This seems like a fair conclusion. After all, fees will have an appreciable impact on performance over time. Case closed. Except it’s not because we live in the real world. First, allow me to discuss a couple issues with these studies. The tone of such articles seems to indicate that simply because an investment manager charges a fee, they should outperform the index. There’s this notion that it’s possible for 100% of active managers to outperform the index. The problem is that the performance of each index is not some arbitrary number pulled out of thin air. The performance of an index is derived from the cumulative effect of active trades. For every winning trade by an active manager, there must be a losing trade on the other side. As such, we’ll never have 90% of active mangers beat an index. I don’t believe we can even have 60% of active managers over time beat the index. Add in the effect of costs and that number drops below 50%.
The second issue I have is that these reports aren’t asset weighted. A small startup fund with limited experience is treated the same as much larger funds. So, when Growth Fund of America with $180B in assets outperforms the index by 4% last year, that means a whole lot of smaller funds are likely on the other side of those trades and consequently will underperform the index.
There is a more constructive conversation that I believe we need to pivot to. Dalbar puts out a study every year that compares returns of the index (or sometimes actual equity funds) to the actual returns that investors experience. Here is what that looks like over various time periods:
Fees alone cannot come close to explaining the difference. Dalbar cites investor behavior as the primary culprit for investor underperformance – specifically behavioral biases of loss aversion and herding. Loss aversion simply means that the pain of a 20% loss is much greater than the pleasure of a 20% gain. This bias typically leads to panic selling on the downside. The herding effect is akin to chasing returns. Investors will invariably follow the latest trends which perpetuates the cycle of buy-high, sell-low.
10% vs 4% over a 30-year time horizon – that equates to a greater than 5-fold difference. Ultimately, that’s where a good advisor earns their keep. You can have the best MoneyGuidePro, Emoney or name-your-software report, but if the client can’t stick to it, it’s just a 30-page pile of paper worth about 25 cents. A good investment plan that a client can stick to is infinitely better than a perfect investment plan that they abandon.