The average person can't dunk the basketball. The average mutual fund manager can't beat their passive benchmark index.
Both of these statements are true. But this doesn't mean that no one can dunk a basketball or that no active manager can beat their index. Obviously some people can dunk a basketball but due to the mainstream media the statement about active managers being able to beat their passive benchmark is not as obvious.
To help you better understand what I’m talking about, a market index is a portfolio or combination of several financial securities or other investment vehicles with their value expressed as a total for purposes of tracking the entire market or at least a sector of the market. For example, large US company index may be expressed as either the Standard & Poor's 500 or the Dow Jones Industrial Average. An index of small US companies is represented by the Russell 2000. An index of bonds is represented by the Barclays Capital Aggregate Bond Index. $152.7 billion has left US stock funds from May 2014 through May 2015. At the same time passively managed funds have increased by $157.2 billion. The popularity of index funds can be traced to low costs and the difficulty of the average mutual fund manager to beat these benchmarks: only 47% of the time have active managers of US stock funds outpaced the S&P 500 during the 20 calendar years ending 12/31/2014.
What if we could screen or use criteria to determine which mutual fund managers might perform better than the benchmarks in the same way that we would screen the average person's probability to dunk a basketball?
I think it's obvious that we would look for tall people to determine the probability of being able to dunk a basketball. If we combine the first criteria of being tall with another criteria of having an above average vertical leaping ability, the probability of success would be even greater.
The research done by The Capital Group in the area of active verses passive investment management has identified three criteria shown to increase the probability of an active manager to beat their benchmark: low expenses, high manager ownership in their funds, and downside capture. Funds that have the lowest expense ratios tended to outpace their index. This obviously makes sense as funds with lower expense ratios have a lower bar to clear to beat their benchmarks. Managers and investment firms who have invested more dollars into their funds tend to outpace the benchmark more often. We believe it's helpful to have the people managing our money, manage their money side-by-side with us. Finally as to downside capture, mutual funds that most frequently were in the best quartile of downside protection tended to outpace the indexes more often.
The Capital Group’s research took all US and international funds in the Morningstar database, then first, subdivided them into the lowest cost, and secondly, those that had the highest manager ownership (of at least $1 million) in their own funds. They then looked at the percentage of each group of funds that had outperformed their respective benchmark over a five and 10 year rolling period going back 20 years from January 1995 through December 2014. Based upon the total universe of funds, over a ten-year rolling timeframe fewer than 28% of the US and international funds outpaced their benchmark and fewer than 30% outperformed over five-year rolling periods. By selecting the 25% of the funds with the lowest cost, your odds of successfully beating the market index rose to just below 50%. If you look at the top quartile (top 25%) for the highest management ownership, roughly 70% of the higher-manager ownership funds beat the US Index and more than 60% of the similarly screened international equity funds top their indices over a ten-year period. For the five-year periods the numbers were 70% and slightly more than 50% respectively. Combining the two screens provided even better results; 100% of the US low-cost, high ownership funds outperform their benchmark over a ten-year period and roughly 90% of the comparable international funds did likewise. Over the five-year rolling periods, the odds of beating the benchmarks using these two selection criteria was over 75%. Adding in the third criteria of downside capture which means greater protection during declining markets, 100% of the top quartile managers using these three screens perform better than their benchmarks. This is especially important when we are in the distribution phase or retirement income payout phase of our lives.
Antti Petajisto did his research around the active/passive management debate when he was a professor at the Stern School of Business at New York University. He focused on “high active share funds”, whose managers were active stock pickers with portfolios that did not look like the index due to their stock selection. His conclusion: active stock share funds in aggregate beat their benchmarks by 1.26% after fees and expenses. He also found that the size of the fund mattered too. The smallest quintile (smallest fifth) combined with the high active share management added 1.84% per year after fees.
Dr. Michael Phillips was a professor of finance at the University of Southern California before taking his current position as chair of the Center for Financial Planning and Investment at California State University at Northridge. He was also a former economist with the US Department of Commerce. His research showed that fiduciary screens helped in determining which active managers could beat their benchmark. He showed that managers and fund companies who put their interests secondary to that of their investors had better returns compared to the benchmarks.
While past results are not predictive of future returns, the historic record shows that low cost, high ownership, active strategies where managers have shown fiduciary intent, have generally outpaced relevant market indices. At New England Capital we use these screens and more, when selecting the funds in your portfolios. We are continuing to do our own research to determine if there are times in market cycles where passive investing has the advantage over active management. If there is a benefit to passive investing we will continue to pursue it. We currently use a combination of passive and active strategies in certain portfolios now.
There is art as well as hard science in our process of building portfolios for both the accumulation and distribution phase of life. If it was easy, it would be a slam dunk for everyone!
The Capital Group.
Bob Veres Inside information, Re-Assessing the Odds.