May 10, 2015

One of the most fundamental decisions every investor faces is active vs passive. This is one of the most hotly contested debates in finance. The active crowd believes that they can “beat the market” with superior stock picking or prescient market timing. The passive crowd believes that it’s not worth the time, effort, and expense to even try. Who is right?

The active crowd points to the success of legendary investors like Buffett, Lynch, and Miller. The passive crowd points to academic studies – some of which were authored by Nobel laureates – to argue that trying to beat the market is a fool’s errand. Where you stand on this issue is of the utmost importance, because you are betting your financial future on the outcome.

Every year, Standard & Poors puts out a report that tracks the actual results of these two very different approaches to investing. It’s called the SPIVA U.S. Scorecard. The report is recognized in the investment community as the closest thing we have to an unimpeachable source on the issue. It includes an annual “League Table” which summarizes the performance of each approach. Here is the most recent version, which includes data for 2014.

SPIVA tableSPIVA tableSPIVA table

Here are a few highlights from the report, which can be viewed in its entirety here.

  • The S&P 500® had its third straight year of double-digit gains in 2014, returning 13.69% (returns were 32.39% in 2013 and 16% in 2012). Based on data as of Dec. 31, 2014, 86.44% of large-cap fund managers underperformed the benchmark over a one-year period. This figure is equally unfavorable when viewed over longer-term investment horizons. Over 5- and 10-year periods, respectively, 88.65% and 82.07% of large-cap managers failed to deliver incremental returns over the benchmark.
  • The returns of 66.23% of mid-cap managers and 72.92% of small-cap managers lagged those of the S&P MidCap 400® and the S&P SmallCap 600®, respectively, on a one-year basis. Similar to the results in the large-cap space, the overwhelming majority of mid- and small-cap fund managers underperformed their benchmarks over the longer-term horizons as well.
  • It is commonly believed that active management works best in inefficient environments, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA Scorecard. The majority of small-cap active managers have been consistently underperforming the benchmark over the full 10-year period as well as each rolling 5-year period, with data starting in 2002.
  • Funds disappear at a meaningful rate. Over the past five years, nearly 24% of domestic equity funds, 24% of global and international equity funds, and 17% of fixed income funds have been merged or liquidated. This finding highlights the importance of addressing survivorship bias in mutual fund analysis.
  • There is nothing novel about the index versus active debate. It has been a contentious subject for decades, and there are few strong believers on both sides, with the vast majority of investors falling somewhere in between. Since its first publication 11 years ago, the SPIVA Scorecard has served as the de facto scorekeeper of the active versus passive debate. Over the past decade, we have heard passionate arguments from believers in both camps when headline numbers have deviated from their beliefs.

And here is the SPIVA table that compares the actual returns of active funds to their corresponding benchmarks.

SPIVA table 2

One of the most popular arguments in favor of active investing is that passive investing means settling for average results instead of trying to do better than average, and that’s not what Americans do. The problem with this line of reasoning is that it ignores the fact that beating the market is very hard to do. And it’s nearly impossible to do consistently, year after year.

But it should also be noted that passive investing is not necessarily the best choice for every investor. Some investors get pleasure out of matching wits with skilled professionals, and they take great satisfaction when they win. Nobody should tell them that what they’re doing is wrong, because for them it’s a matter of personal preference. The choice of active vs passive investing is not a settled issue on an investor-by-investor basis.

The problem I have with active investing is that too many investors have been sold a bill of goods by the investment industrial complex. They have been told that active investing is a superior approach, and the odds of success are better than they are with a passive approach. This is clearly not the case, as the  numbers show.

If you want to invest actively, and try to beat the market, I encourage you to go for it. Just be aware that it’s a rough game, and you’re going up against professionals who are better informed, have better skills, and do this full time.

About the author 

Erik Conley

Former head of equity trading, Northern Trust Bank, Chicago. Teacher, trainer, mentor, market historian, and perpetual student of all things related to the stock market and excellence in investing.

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