The evidence suggests most active managers can’t and don’t outperform the index
Fortunately for participants in the perennial active/passive debate, whether active managers can outperform a market-cap weighted index is ultimately an empirical question. On this score, the evidence seems overwhelmingly in favour of passive investment – both in Australia and overseas. According to the latest SPIVA Australia Scorecard by S&P Dow Jones Indices, charted above, for example, a full ~78% of active Australian general equity managers underperformed the S&P/ASX 200 Index over the five years ending December 2014. The performance of local international equity managers, Australian fixed-income managers, and listed property managers was in fact somewhat worse. Over the latest 3-year period, the scorecard was slightly better for Australian equities active managers, although 6 in 10 managers still underperformed.
Of those active managers that do outperform over a certain period, such outperformance is unlikely to persist
As seen in the chart, it turns out that only 24% of the 29 funds identified by Mercer as enjoying top quartile investment performance in the three-years to September 2010, were also able to produce top-quartile performance in the three-years to September 2013. In fact, statistically speaking, the most likely scenario (31%) is for a top quartile performer in the first period to end up becoming a fourth quartile performer in the second period! Meanwhile, almost one in five of these top performing funds ceased operation (or were merged/taken-over) in the second three-year investment period.
Indeed, according to the Mercer Survey, of the 32 funds with top quartile performance in the three-years to September 2013 (among 126 funds covered), 16 – or 50% – of these funds were new to the market.
As they dominate the market, it’s hard for all active managers to outperform all of the time
Due to the fact that institutional money – which is still predominantly active in nature – tends to dominate ownership and therefore trading in the Australian equity market, it stands to reason that not all managers (who effectively “are” the market) can outperform the market all of the time. This is because for every ‘winning’ trade, there will equally be a ‘loser’ on the other side. As seen in the chart below, of the $1.6 trillion worth of “listed and other” equities in Australia as at end-December 2014, a whopping $1.4 trillion – or 83% – was owned either by domestic insitutional investors, or foreign owers (which are also largely institutional). Households directly owned only around $200 billion, or 13%. With active managers owning around 80% of the market, their collective attempt to beat the market is akin to a zero-sum game.
It’s also important to know that, due to the development and continued innovation in indexation – there are now a number of indices which recognise the limitations of traditional market-cap weighted indices, including some offered by my firm, BetaShares. These ‘smart beta’ indices, such as, for example, fundamental weighted indices, combine the benefits of index funds (i.e. low cost, transparent, diversified, rules based) along with the potential to outperform the market-cap benchmark.
We’re a long way from passive investment distorting the market
There has been some conjecture that the continued growth of index investing and ETFs may contribute to potential market distortions. Truth is, we’re a long way away from that. According to Morningstar Research estimates, passive investment strategies have accounted for around 8% of the Australian managed funds industry in recent years – at these levels its unlikely rebalances in such products will be a major influence on market pricing. With only ~$18 billion funds under management, moreover, ETPs account for only ~0.7% of the $2.4 trillion managed funds industry as at March 2015.
That said, even in the United States – where passive investment is estimated to account for a much larger 24% of funds under management in 2013 – it still seems evident that active managers have a hard time beating the market. According to S&P’s latest survey, for example, 88% of large-cap US managers failed to beat the S&P 500 index in the 5-years to end-2014.
With all that said, there is no doubt that there do exist a select number of active managers who have a strong track record of persistent outperformance. At BetaShares, we firmly believe that active management has a role to play in investors’ portfolios, and often find ourselves discussing how ETFs can be used in combination with high quality active managers. However, when considering the active vs. passive debate, we believe it’s important to be armed with the empirical facts.