What is Active and Passive Investing?
Active fund managers attempt to beat the market (or their particular benchmark) by picking and choosing among individual securities as well as deciding when to be fully invested or not. Passive fund managers (who are not, in our opinion, limited to index funds) focus on capturing the return of a market or market segment in a low-cost manner.
It is clear to us that the overwhelming majority of financial academic studies highlights the failure of the timing and selection that underlies active management. One such study is “Luck versus Skill in the Cross-Section of Mutual Fund Returns” by Eugene Fama (2013 Nobel Laureate in Economics) and Ken French published in the October 2010 issue of The Journal of Finance. The authors found that:
“The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors…few funds produce benchmark-adjusted expected returns sufficient to cover their costs.”
Not one to mince words, Professor Fama later remarked in an interview published in the Nov/Dec 2012 issue of the Financial Analysts Journal,
“An investor doesn't have a prayer of picking a manager that can deliver true alpha."
So how have active funds fared since this study was published?
The answer is provided by the SPIVA U.S. Scorecard published semi-annually by S&P Dow Jones Indices. The mid-year Scorecard for 2023 report was published on September 21, 2023 and is consistent with all the past versions in that it shows the majority of actively managed funds failing to beat a risk-appropriate benchmark. In general, the longer the evaluation period, the worse is the performance for active managers. The newly available twenty-year results are especially unfavorable with 94% of large-cap managers, 95% of mid-cap managers, and 94% of small-cap managers failing to beat their benchmarks. Likewise, over the twenty-year investment horizon, managers across all four international categories underperformed their benchmarks. Lastly, for fourteen categories of fixed income funds over the fifteen-year period, the results are the same (underperformance across the board). The companion report to the SPIVA U.S. Scorecard is the Persistence Scorecard, and it clearly shows that any outperformance observed tends to vanish over time. Wise investors refrain from playing the game of chasing the manager with the "hot hand." Acceptance of the superiority of passive over active is the essential first step in becoming a prudent investor.