In the asset management world, the semiannual release of S&P Dow Jones’s SPIVA (S&P indexes versus actively managed funds) report generally gets a reaction. It’s simultaneously greeted with cheers and jeers—“I told you so”; “yeah, but”; “you’re hired”; and “you’re fired.”
SPIVA’s detailed summary of the performance of actively managed funds versus various S&P benchmarks also sets off a mad scramble by bloggers, journalists, and other investment writers and commentators to interpret the results. And 2015 has been no different. As cash flows continue to gravitate toward passive vehicles,¹ I thought I’d offer my two cents on the eternal actively managed versus passive debate.
Of course, if you’ve read any of my previous blogs, you’ll know that my two cents isn’t always as simple as a pair of pennies. In other words, I’m not going to beat the drum (much …) on passive outperforming actively managed over time. It’s not just a matter of whether a majority of actively managed funds underperform a comparative benchmark in the short or long run. Instead, I’m going to approach the benefits of incorporating passive management into client portfolios from a different angle—the ability to invest responsibly for a given goal.
By responsible investing, I mean limiting poor behavior, such as return chasing and market-timing. To demonstrate, I asked my colleagues in Vanguard Investment Strategy Group to calculate investor returns (internal rate of return, or IRR) and fund returns (time-weighted return or TWR) for both actively and passively managed U.S. equity funds in the Morningstar database.
Before I jump into any interpretation of data, there are two important caveats:
- IRR has as much to do with the timing of investor cash flows as with the sequence of returns in the fund. Therefore, in any individual example, a low or high IRR relative to a fund’s TWR should not be blindly interpreted as poor or great market-timing ability. But when viewed across like funds over common periods, we can begin to gain more confidence in our interpretations.²
- Specific values are highly dependent on the period selected. In other words, we shouldn’t assume that the IRR for growth funds will be higher than the returns for the funds themselves, despite the results of the last ten years. That said, we would expect the broader the index, the better investors will track that index.
Now let’s look at what our additional data on IRR and TWR shown in the figure below.
There are a number of take-aways, but I’m going to focus on the three most important.
- The average return for index managed funds is greater than the average return for actively managed funds in a majority of the style boxes.³ This finding parallels the SPIVA report.
- The difference between the IRR and TWR for investors in index managed funds is, on average, much lower than for investors in actively managed funds.
- The combination of points 1 and 2 means that investors in actively managed funds have faced a stiff headwind.
Ultimately, what we can conclude is that when an investment’s return deviates from an index, or when a narrowly defined index deviates from the broad market, investors’ returns will more consistently lag and by greater margins.
Therefore, while you may be tempted to build complex portfolios in the name of diversification, or in hopes of delivering market outperformance through more and narrower options, what we see is underperformance, not only by investment funds but also, and more important, by the investors themselves!
Of course, there’s nothing wrong with actively managed funds; but you and your clients should expect actively managed funds to have wider ranges of returns because of their greater risk, by definition. In turn, you should recognize that wide performance variations make it more difficult for people to stay the course. Unfortunately, experience and data tell us that investors are highly likely to be influenced by swings in absolute and relative performance. They tend to buy high and sell low—part of the reason the results above look the way they do.
So what can we do? Well, if the objective is to ensure the greatest probability of success for those who depend on it, increasing one’s allocation to passive investment options is one way that may help.
My thanks to Yan Zilbering for his assistance with this blog.
1 For the [TIME PERIOD ENDED] August 31, 2015, investors moved $38.5 billion into passive equity funds versus $114.2 billion out of actively managed equity funds, and they moved $41.3 billion into passive fixed income funds versus $8.4 billion into actively managed fixed income funds, according to Morningstar, Inc.
2 For a detailed discussion of this phenomenon as it relates to Vanguard ETFs® and funds, see Francis M. Kinniry Jr. and Yan Zilbering, 2012. Evaluating dollar-weighted returns of ETFs versus traditional fund returns. Valley Forge, Pa.: The Vanguard Group. In addition, the implication of the timing of investor cash flows are discussed in Donald G. Bennyhoff and Francis M. Kinniry Jr., 2013. Advisor’s Alpha, Valley Forge, Pa.: The Vanguard Group
3 This is not the best methodology with which to evaluate passive versus active, but it suffices for this example. For a more robust analysis of how actively managed funds have fared, refer to Christopher B. Philips, Francis M. Kinniry Jr., Todd Schlanger, and Joshua M. Hirt, 2014. The case for index-fund investing. Valley Forge, Pa.: The Vanguard Group.
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.