Although I dont spend a ton of time watching the financial news, I see more than enough of the misinformation that too many people seem to regard as factual.
Last week I was appalled (though not totally surprised) to see a commentator describe 2018 as likely to be a stock pickers year.
This is the stupidest sales pitch for active management that I know. And I dont think stupid is too strong a word.
The idea seemed to be that theres something special about this coming year that will give active managers an advantage over index funds.
Of course there was no convincing evidence, because none can exist. The one fact I am sure of is this: Nobody can know what the markets will bring this year. Nobody.
In theory, it is possible that most active mutual-fund managers will outperform their benchmarks this year.
But is that likely? Not very.
In fact, the evidence points in only one direction: Active management (or stock picking if you prefer) is a losers game.
The purported goal of active management, of course, is to beat the market. And while the market can be defined in various ways, most investors are (or should be) willing to accept the S&P 500 index as a good benchmark.
Mutual fund marketing departments like to make people think the S&P 500
is easy to beat. Academics say the opposite.
Lets look at some facts, as compiled and presented in a semiannual report known as SPIVA and produced by S&P Dow Jones Indices LLC, a part of S&P Global.
This report compares the returns of all actively managed mutual funds to the returns of public indexes.
The latest report, covering returns through June 30, 2017, includes many asset classes, but I can make my point with four: U.S. large-cap funds, U.S. midcap funds, U.S. small-cap funds and U.S. small-cap value funds.Related: Best Stocks To Buy For 2018
I include small-cap value for two reasons.
First, in my opinion it is an extremely important asset class for long-term investors.
Second, its an example of a market niche that supposedly can be exploited by shrewd stock pickers.
The following data is unequivocal: It shows that active management is a losers game. (Results are for periods ending June 30, 2017.)
Of all large-cap funds, 56.6% fell short of the S&P 500 for one year; 81.6% failed to meet it for three years; 82.4% failed for five years. In other words, the majority of funds were losers for one year, and the vast majority were losers over three years and five years.
Among midcap funds, 60.7% were unable to meet the S&P Midcap 400 Index
for one year. For three years and five years, the failure rate was the same: 87.2%.
Small-cap funds were similarly unsuccessful: 59.6% failed to match the S&P Small-Cap 600
or one year. For three and five years, the failure rates were 88.7% and 93.8%, respectively.
OK, but what about small-cap value funds, the niche that gives active managers a special opportunity?Related: Top Stocks To Buy For 2018
Alas, 62.7% of small-cap value funds failed to meet the returns of the S&P Small Cap 600 Value Index
for the one-year period. The longer-term failure rate was dismal: 92.5% for three years and 95.2% for five years.
In plain language, heres what this means:
If you chose a large-cap fund, you had less than two chances in 10 of beating the market for either three or five years.
If you chose a small-cap fund, your chances of beating the market were less than two in 10 over three years and less than one in 10 over five years.
In small-cap value funds, you had less than one chance in 10 over either three years or five years.
Midcap funds followed the same pattern, giving you less than two chances in 10 over either three or five years.
These facts lead to an inescapable conclusion: All the brains and hard work and sophisticated technology available to Wall Street arent enough to let most funds even match let alone beat their benchmarks.
However, there is still lots of money to be made from gullible investors whose hopes and dreams are strong enough to override the facts.
Selling active management is an uphill battle for Wall Street, but its still being fought. Lets examine some of Wall Streets claims.
Our managers have beaten the market is an intriguing sales pitch. And more often than you might think, that misleading fact could be true. How is that misleading?
The answer involves the concept of survivorship bias. If a mutual-fund company starts out with 20 managers and only half of them beat the market, it can fire the other half. At that point, the fund company can legitimately claim that every one of its managers beat the market.Related: Best Stocks To Buy For April 2017
Survivorship bias applies to funds themselves as well as managers.
If the Acme Fund Company begins a year with 15 funds, and five lose money, it can simply close the five losers, then legitimately claim that every one of its funds made money last year.
(SPIVA tracks the number of funds that are closed or merged away, normally for bad performance. For the last 15 years in the study only 41.7% of all U.S. equity funds that started the period are still in existence.)
The matter of money
One reason its so hard to beat indexes is that all those managers, all that research, all that marketing costs money. And who pays? The shareholders pay. They pay in the form of continuing expenses that lead to diminished returns.
Index funds often charge less than 0.1% a year in expenses. Actively managed funds often charge 10 times that much.
The shell game
Mutual fund marketing departments can find sneaky ways to distort the truth.
This fund actually beat the market could mean that the market was a significantly different asset class or mix of asset classes. For example, a U.S. fund may hold unusually large stakes in international companies, and when international stocks are outperforming U.S. stocks, this U.S. fund looks like a great winner.
Heres another pitch you might hear:
Actively managed funds can protect investors in a bear market by selling stocks, while an index fund has to sit back and just take a beating.
That sounds plausible. But if this were actually a real advantage, then this protection should have made actively managed funds stand out during the severe bear market of 2008.
In fact, less than one of three actively managed funds beat their benchmarks in that year an even worse comparative performance than usual for active managers.
So much for the benefits of a managers theoretical safety net!
For more, check out my podcast, The Number One Table of Investment Returns.
Richard Buck contributed to this article.