The argument behind passive investing, and the reason it has been the overwhelming choice of investors over the past decade, is simple: data has repeatedly shown that not only does it offer an extremely high likelihood of better long-term performance, but it does so for vastly lower costs.
About the latter point there is no dispute. Passively managed funds — which simply mimic the performance of an index like the S&P 500 SPX, -0.63% rather than trying to outperform a benchmark through individual security selection, as with an actively managed one — are significantly cheaper, one of primary reasons that investors have poured hundreds of billions of dollars into them in recent years, redeeming a similar amount from active ones.
According to data from Morningstar, actively managed funds carried an average fee of 0.72% in 2017, nearly five times the 0.15% average charged by passive funds. An actively managed product would have to do significantly better than the index over time to be worth the additional cost.
Many active managers argue that this is possible, particularly in periods of volatility or market weakness. Recently, they have pointed to short-term performance statistics that have indeed trended in their favor. According to May data from Goldman Sachs, 56% of large-cap mutual funds have outperformed their benchmark so far this year, putting them on track for their best year of relative performance since 2007.
Over the longer term, however, the ability of active managers to beat their benchmark drops precipitously. And while the results are marginally better when adjusted for risk, doing so doesn’t change the trend.
According to data from S&P Dow Jones Indices, a huge majority of actively managed equity funds fail to outperform their benchmarks on 5-year, 10-year, and 15-year time frames. This holds for every category of fund (including large-capitalization stocks, midcaps, and small-caps), as well as for the primary investment styles (core, value, and growth). There are even some categories and time horizons where fully 100% of active funds fail to beat their benchmark.
The results are overwhelming when they are considered on a net-of-fee basis, and while active managers boast somewhat better results when they are considered on a gross-of-fees basis, the shift isn’t enough to change the trend. With one exception investors are better off in passive, regardless of the investment style or category being considered. With only a few exceptions, investors have better-than-even odds of doing better in a passive product.
“The results show that across all categories, actively managed domestic equity funds, on average, underperformed their respective benchmarks over intermediate- and long-term investment horizons,” S&P Dow Jones wrote in a news release announcing the results.
In the case of funds focused on large-cap equities — funds that would be compared against the S&P 500 — fully 96.76% of the funds did worse than the benchmark over a five-year period, as of data through the end of 2017. That’s on a net-of-fees basis. On a gross-of-fees basis, 88.34% of funds fail to beat the S&P.
Over a 10-year period, the S&P beats 90.66% of active funds on a net-of-fees basis, while it does better than 95.03% on a 15-year time horizon. Gross of fees, the S&P does better than 75.08% of actively managed funds over a 10-year stretch, and better than 83.52% over the past 15 years.
The following table shows the performance statistics across the equity categories.
There are only three points on the chart where fewer than 50% of actively managed underperform the benchmark, and all three come when considered on a gross-of-fee basis. Two of these occurrences are in real-estate funds. On a five-year basis, the S&P United States REIT Index — the benchmark for the category — does better than just 28.95% of actively managed real-estate funds. On a 15-year basis, it outperforms 43.4% of funds.
The third example comes in the category of large-cap value funds, where on a 10-year basis, 48.77% of funds underperform.
Of course, even in such categories, the investor has to pick the fund that will end up doing better than the benchmark over time. This is seen as such a difficult thing to predict that last year, Morningstar said most investors shouldn’t even bother trying.
“Identifying a successful active fund in advance turns on numerous, subjective factors, and the importance of these factors can shift around over time,” wrote Jeffrey Ptak, the firm’s global director of manager research. “This alone is usually too much for most people to handle. Add to that the fact that even the winningest funds slump and investors, lacking the resolve to stick with it, bail. Take those two together and it argues that active-fund selection belongs in what Warren Buffett has called the ‘too hard pile.’”
