The following is an excerpt from The Investment Answer. It's a small, easy read with very nicely designed charts and graphs (which I couldn't put in a post so I have included them in red below.) Much of what the authors say here are reasons why I choose to invest in index funds. If you've ever wondered why passive investing beats active investing, this article is for you.
Active managers attempt to “beat the market” (or their relevant benchmarks) through a variety of techniques such as stock picking and market timing. In contrast, passive managers avoid subjective forecasts, take a longer-term view, and work to deliver market-like returns.
The Efficient Markets Hypothesis asserts that no investor will consistently beat the market over long periods except by chance. Active managers test this hypothesis every day through their efforts to outperform their benchmarks and deliver superior risk-adjusted returns. The preponderance of evidence shows that their efforts are unsuccessful.
[The list below] shows the percentage of actively managed equity mutual funds that failed to outperform their respective benchmarks for the five-year period ending December 31, 2009. The message here is that most funds failed to beat their respective benchmarks. (If international small-cap managers had been correctly compared to an index that included emerging markets, the rate of underperformance would rise to the 70 to 80 percent range, which is in line with the other categories.)
Active Managers Failing to Beat Their Benchmark (%) - January 1, 2005 – December 31, 2009
- US Large Cap -- 61%
- US Mid Cap -- 77%
- US Small Cap -- 67%
- Global -- 60%
- International -- 89%
- International Small -- 27%
- Emerging Markets -- 90%
Source: Standard & Poor’s Indices Versus Active Funds Scorecard, March 30, 2010. Indicies used for comparison: US Large Cap—S&P 500 Index, US Mid Cap—S&P Mid Cap 400 Index, US Small Cap—S&P Small Cap Index, Global Funds—S&P Global 1200 Index, International—S&P 700 Index, International Small—S&P Developed ex.-US Small Cap Index, Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survior-Bias-Free US Mutual Fund Database. Results are net of fees and expenses. Indices are not available for direct investment.
Active managers attempt to outperform the market (or a benchmark index) by assembling a portfolio that is different from the market. Active managers think they can beat the market through superior analysis and research. Sometimes, these managers consider fundamental factors such as accounting data or economic statistics. Others will perform technical analysis using charts and graphs of historical prices, trading volume, or other indicators, believing these are predictive of future price movements.
For the most part, in an attempt to beat their benchmarks, active managers will make concentrated bets by holding only those securities they think will be the top performers and rejecting the rest. This approach, of course, comes at the expense of diversification. It also makes it difficult to use active strategies in a portfolio to reliably capture the returns of a target asset class or control a portfolio’s overall allocation.
Studies show that the returns of active managers can be very different from their benchmarks, and their portfolios often overlap across multiple asset classes.
There are two primary ways that active managers try to beat the market: (1) Market timing, and (2) Security selection.
Market timers attempt to predict the future direction of market prices and place a bet accordingly. Because no one can reliably predict the future, it should come as no surprise that the overwhelming evidence suggests market timing is a losing proposition.
Another reason it is so hard to time markets is that markets tend to have bursts of large gains (or losses) that are concentrated in a relatively small number of trading days. [The information below] shows that if an investor misses just a few of the best performing trading days, he loses a large percentage of the market’s total returns. We believe it is impossible to predict ahead of time when the best (or worst) days will occur.
Performance of the S&P 500 Index -- Daily: January 1, 1970 – December 31, 2009 - Growth of $1,000 (Annualized Compound Return)
- Total Period - $43,119 (9.87%)
- Missed 1 Best Day - $38,667 (9.57%)
- Missed 5 Best Single Days - $28,036 (8.69%)
- Missed 15 Best Single Days - $16,281 (7.22%)
- Missed 25 Best Single Days - $10,339 (6.01%)
- One-Month US T-Bills - $10,176 (5.70%)
Data for January 1970-August 2009 provided by CRSP. Data for September 2008-December 2009 provided by Bloomberg. S&P data provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Treasury bills data © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago. Indices are not available for direct investment. Performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. There is always a risk an investor will lose money.
The other active management technique is security selection (or stock picking). This involves attempting to identify securities that are mispriced by the market with the hope that the pricing error will soon correct itself and the securities will outperform. In Wall Street parlance, an active manager considers a security to be either undervalued, overvalued, or fairly valued. Active managers buy the securities they think are undervalued (the potential “winners”) and sell those they think are overvalued (the potential “losers”).
You should know that whenever you buy or sell a security, you are making a bet. You are trading against the view of many market participants who may have better information than you do. When markets are working properly, all known information is reflected in market prices, so your bet has about a 50% chance of beating the market (and less after costs are taken into account).
Again, Wall Street and the media have a vested interest in leading us to believe that we can beat the market if we are smarter and harder-working than others. Yet, through today’s technological advances, new information is readily available and becomes almost instantly reflected in securities prices. Markets work because no single investor can reliably profit at the expense of other investors.
The idea that prices reflect all the knowledge and expectations of investors is known in academic circles as the Efficient Markets Hypothesis, which was developed by Professor Eugene Fama of the University of Chicago Booth School of Business.
The Efficient Markets Hypothesis is sometimes misinterpreted as meaning that market prices are always correct. This is not the case. A properly functioning market may get prices wrong for a time, but it does so randomly and unpredictably such that no investor can systematically outperform other investors, or the market as a whole.
Finding the Winning Managers
Still, many investors want to believe that they will be able to beat the market if they can identify a smarter, harder-working, and more talented manager — a Roger Federer or Michael Jordan of money management. Of course, it is easy to find a top performer after the fact. They are then held out as “geniuses” by the media. But how do you identify tomorrow’s top managers before they have their run of good performance?
The most common method is by examining past performance, the theory being that good past performance must mean good future performance. Financial magazines like Forbes, and rating services such as Morningstar, love to publish this data as these are some of their best selling issues. Mutual fund companies are also quick to advertise their best performing “hot funds” because this attracts new money from investors. Despite all of this activity, there is little evidence to suggest that past performance is indicative of future performance.
A more sensible approach to investing is passive investing. This is based on the belief that markets are efficient and extremely difficult to beat, especially after costs. Passive managers seek to deliver the returns of an asset class or sector of the market. They do this by investing very broadly in all, or a large portion of, the securities of a target asset class.
The best known (but not the only) method of passive investing is called indexing, which involves a manager purchasing all of the securities in a benchmark index in the exact proportions as the index. The manager then tracks (or replicates) the results of that benchmark, index less any operating costs. The most popular benchmark index is the S&P 500, which is comprised of 500 U.S. large cap stocks that currently make up about 70 percent of the market capitalization of the U.S. stock market.
Because active managers are always looking for the next winner, they tend to keep more cash on hand so they can move quickly when the next (perceived) great investment opportunity arises. Since the return on short-term cash investments is generally much less than that of riskier asset classes like equities, holding these higher cash levels can end up reducing an active manager’s returns. Passive managers are more fully invested, which means that more of your money is working for you all the time.
Another advantage of passive investing is that you and your advisor can select a group of asset classes that work well together like the efficient building blocks of a portfolio. Done correctly, the building blocks will have few securities in common (called cross-holdings) and the risk and return profiles of each will be unique.
Sometimes an active manager will change his investment style in an attempt to beat his benchmark. For example, a large cap value manager may suddenly start purchasing large growth stocks if he feels that large growth stocks are about to take off. This “style drift” can be problematic, especially if you already have a large growth fund in your portfolio. In this case, you would now have overlapping risk and less diversification. Trying to build a portfolio using active managers causes you to lose control of the diversification decision.
One explanation for the underperformance of active management was set forth by Nobel Laureate William Sharpe of Stanford University.
Sharpe ingeniously pointed out that, as a group, active managers must always underperform passive managers. This is because investors as a whole can earn no more than the total return of the market (there is only so much juice in an orange). Since active managers’ costs are higher— they pay more for trading and research — it follows that the return after costs from active managers as a group must be lower than that of passive managers.
This holds true for every asset class, even supposedly less-efficient ones like small-cap and emerging markets, where it is often said that active managers have an edge because information is less available. Sharpe’s observation confirms that because of their higher costs in these markets, active managers should collectively underperform by more than in larger, more widely traded markets — the opposite of convention wisdom.
The higher costs of active management can be broken down into three categories:
1. Higher manager expenses. It is more costly for an active manager to employ high-priced research analysts, technicians, and economists, all of whom are searching for the next great investment idea. Other active management costs include fund marketing and sales costs, such as 12b-1 fees and loads, to attract money from investors or to get Wall Street brokers to sell their funds. The expense differential between active and passive approaches to investing can exceed one percent per year.
2. Increased turnover. As active managers try to provide superior returns, they tend to trade more often and more aggressively than passive managers. This usually means paying greater brokerage commissions, which are passed on to shareholders in the form of reduced returns. It also means that market-impact costs can increase dramatically. When an active manager is motivated to buy or sell, he may have to pay up significantly in order to execute the transaction quickly or in large volume (think of a motivated buyer or seller in real estate).
These higher market-impact costs are more prevalent in less liquid areas of the market such as small cap and emerging markets stocks. It is not uncommon for turnover in actively managed funds to exceed that of index funds by four times or more. The extra trading costs for active management can exceed one percent per year.
3. Greater tax exposure. Given that active managers trade more often, it follows that taxable investors will incur accelerated capital gains as a result. Remember, if your mutual fund sells a security for a gain, that profit may be passed on to you as a taxable distribution. For securities held longer than one year, you would pay the long-term capital gains rate, while short-term capital gains would apply for securities held less than one year. The additional taxes due to accelerated capital gains generated by active managers may exceed one percent per year.
It is important to understand that of these three categories, typically only manager expenses are disclosed to investors. These are usually expressed as a percentage of net asset value in the case of a mutual fund, and is called the operating expense of the fund. For actively managed equity funds, the average operating expense ratio is around 1.3 percent per year. Passive funds, on the other hand, can cost much less than 0.5 percent.
If the additional costs of active management run roughly two to three percent annually, then the active manager clearly faces a huge hurdle just to match the results of a passive alternative such as an index fund.
[The information below] compares the ending value of a hypothetical investment (growing at a rate of eight percent per year before fees) at various rates of annual investment expenses. Notice how every incremental percent in costs can add up and reduce your long-term ending wealth.
Pay attention to the costs you pay!
Costs Matter - Growth of $1 Million: 8% Gross Return for 30 Years
- Annual Investment Expenses 1% -- $7,612,225
- Annual Investment Expenses 2% -- $5,743,491
- Annual Investment Expenses 3% -- $4,321,942
Assumes eight percent return before costs and no taxes paid. Net initial investment of $1 million. For Illustrative purposes only.