Active vs. Index Investing in Down Markets

This post was originally published in Portland Business Journal’s Financial Services Guide on July 10, 2020. You can see the original article here.

Warren Buffett famously said, “It’s only when the tide goes out that you learn who’s been swimming naked.” Recent stock market performance suggests active fund managers are again scurrying for their towels.

The Daunting Odds Against Stock-Picking Strategies

Historical performance data indicates that most active investment managers, those who tout their stock-picking and market-timing abilities, fail to outperform the market.

In any given year, about 60% of professional stock pickers underperform a relevant market benchmark. Stretch the evaluation period to 10 years and roughly 70% underperform. Over 15-year periods, the number of active managers who fail to match market returns reaches staggering proportions.

In its most recent “S&P Indices vs. Active” (SPIVA) Scorecard, S&P Dow Jones reported nearly 89% of U.S. stock funds across all asset classes failed to outperform their benchmarks for the 15 years ended 2018.

That’s right, you’ve got about a 1-in-10 chance of picking a single fund that will simply match the market’s return over your investment horizon. Putting together an entire portfolio? Your odds are probably closer to 1 in 100.

Active Management: Theory vs. Reality

Active managers dismiss this underperformance by suggesting market conditions temporarily favored buy-and-hold index investing—too much correlation, not enough dispersion in stock returns, or too little market volatility. Their stories aim to convince investors the next “stock-picker’s market” is just around the corner.

In theory, this sounds appealing. While owners of index funds must accept whichever way the market winds are blowing, active managers can load up on hot stocks during surges, favor defensive industries during corrections, or sidestep bear markets entirely by holding more cash.

The pandemic-gripped markets from February through April brought the dizzying daily price swings and wide dispersion between winning and losing stocks that active fund managers have long claimed provide the exact conditions to outperform.

So, how did they do? Not well.

Taking Stock of Active Management Outcomes

Mutual fund database Morningstar reported performance for actively managed stock-picking funds across nine different asset classes from February to April 2020. For each, they list the percentage of funds that outperformed their index benchmarks.

In six of the nine asset classes, fewer than 50% of actively managed funds beat the market. For example, just 23% of funds in the U.S. small cap blend category outperformed their index benchmark, while only 38% of U.S. large cap growth and 30% of diversified emerging markets funds outperformed.

The relative bright spots for active managers came in the foreign large blend and U.S. large cap value categories, where 65% and 61% respectively outperformed. Keep in mind, this was during a period when stock-picking conditions were supposedly ideal.

Some will be unconvinced by this latest evidence. They might prefer to spin the data differently, pointing to the losing categories of active funds and compellingly argue there was something “different this time” that temporarily favored the index averages.

On the flip side, some might point to the number of winning actively managed funds in each category. Sure, 62% of international small cap funds underperformed, but that means 38% outperformed—we’ll put our money with them.

Today’s Winners Are Often Tomorrow’s Has-Beens

There’s a fatal flaw in this reasoning: investors cannot depend on short-term winners to outperform in the future. Two recent studies illustrated that winners don’t repeat:

• The Vanguard Group separated active funds into pools of winners and losers based on their performance from 2007 to 2011. It then tracked the winners’ performance over the subsequent five years (2012 to 2016) to determine how many remained top performers. Past winners were more than twice as likely to fall to the losers’ category (or go out of business entirely) than to remain top performers.
• Dimensional Fund Advisors tracked the performance of all actively managed stock mutual funds from 2005 to 2019 to determine how many market-beating managers stayed at the top five years later. Dimensional found just 21% of past winners continued their winning ways over the next five-year period.

In other words, if you think you can look at a winning fund manager’s performance track record as a sign of future success, there’s about an 80% chance you’re wrong.

The numbers don’t lie. Active fund managers are no more skilled at protecting your life’s savings in a crushing global pandemic than they are at adding value when stock markets are setting record highs.

Pool Your Investments in Low-Cost Index Funds

This harsh reality of underperformance led the CEO of the world’s largest association of investment managers to remark “the tide has gone out and the emperor has no clothes.” It should be telling when the head of the global organization largely responsible for minting new stock pickers agrees with Warren Buffett.

While active managers again got caught swimming naked, the greater evidence still suggests that a patient, diversified approach using low-cost index funds remains the best way to stack the investment odds in your favor.