Something we often hear is that, as more and more investors choose to index, the opportunities for active investors to beat the market are growing. In fact the opposite is true, as LARRY SWEDROE explains.
The trend toward indexing, and more generally passive investing (defined as “no individual security selection or market timing”), has been inexorable, although slow, for the past 25 years. However, thanks to the publication of more and more research on the persistent failure of active management, the trend has accelerated over the past 10 years.
According to Morningstar, at the end of December 2008, $4.6 trillion was held in actively managed funds versus just $1.1 billion in passive funds (19 percent of the total). Ten years later active funds held $10.4 trillion and passive funds held $6.4 trillion (38 percent of the total)—a doubling of passive’s market share.
In US equities the gap has closed even faster. Morningstar data shows that as of the end of April, the two were virtually even with $4.3 trillion in assets. Morningstar predicts that by the time you read this, passive funds will have taken the lead.
One of the arguments you often hear from the active management faithful is that as more and more investors abandon active strategies, the markets will become less efficient, enabling the remaining active managers to exploit pricing mistakes. As the chief research officer for Buckingham Strategic Wealth, I’m often asked to address this issue.
Look at the data
The best way to address such questions is with the facts — data. With that in mind, we’ll begin with a look at my trusty videotape. If the belief that active management’s performance would improve as passive’s market share grew were correct, we would see evidence of that in the data provided by S&P Dow Jones Indices in their annual SPIVA Scorecards. The most recent 2018 SPIVA Scorecard showed that over the five-year period ending 2018, 84 percent of U.S. large-cap managers, 85 percent of US mid-cap managers and 91 percent of U.S. small-cap managers lagged their respective benchmarks—an average failure rate of 87 percent. Looking back at my review of the 2012 Scorecard (the first one I wrote about), I found that the figures were 75 percent, 90 percent and 83 percent, respectively. That’s an average failure rate of 83 percent. We can go back further and look at the 2008 Scorecard, when passive’s share was only half that of today. The respective failure rates were 72 percent, 79 percent and 86 percent—an average failure rate of 79 percent.
While active managers want you to believe that their odds of success will increase due to the decreasing competition for information, we see exactly the opposite occurring, as the average five-year failure rate rose from 79 percent in 2008 to 83 percent in 2012 and to 87 percent in 2018! When the data doesn’t fit your theory, throw out the theory!
Having reviewed the data, let’s turn to explaining this seemingly “contrary” result. Because of the zero sum (before considering implementation costs) nature of the game of active management, for some managers to outperform, they must exploit the mistakes of others. It seems likely that those abandoning active management in favour of passive strategies are investors who have had poor experience with active investing; it’s not likely that an individual would abandon a winning strategy.
The only other logical explanation I can come up with is that an individual simply recognised that they were lucky. That conclusion would be inconsistent with behavioral studies that show individuals tend to take credit for their success as skill-based, and attribute failures to bad luck. Thus, it seems logical to conclude that the remaining players are likely the ones with the most skill. In terms of funds, those with poor performance lose assets and eventually are either merged out of existence (to make their poor performance disappear) or shut down as investors flee. Again, the remaining players are likely more skilful than those who abandoned the game.
Therefore, we can conclude that as the less skilled investors abandon active strategies, the remaining competition, on average, is likely to get tougher and tougher. And it becomes a vicious circle, as with each round of dropouts the remaining competition is more skilled. It’s just like playing at Wimbledon — as you progress through each round, the remaining competition is likely to be tougher. And that brings us to the paradox of skill.
The paradox of skill
What so many people fail to comprehend is that in many forms of competition, such as chess, poker or investing, the relative level of skill plays the much more important role in determining outcomes, not the absolute level. What is referred to as the “paradox of skill” means that even as skill level rises, luck can become more important in determining outcomes if the level of competition is also rising.
In a 2014 issue of the Financial Analysts Journal, Charles Ellis, one of the most respected people in the investment industry, noted: “Over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition. … They have more advanced training than their predecessors, better analytical tools, and faster access to more information.”
Legendary hedge funds, such as Renaissance Technology, SAC Capital Advisors and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases. They are much more skilled than the average fund manager of 20, and even 10, years ago. According to Ellis, the “unsurprising result” of this increase in skill is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.”
The bottom line
As investors continue to learn about the evidence against active management as the winning strategy as well as “benefit” from their own experiences with actively managed mutual funds, the questions about the implications for passive’s growing market share will continue. And my answer will be the same — the odds of success are getting smaller and smaller.
LARRY SWEDROE is Director of Research for Buckingham Asset Management and The BAM Alliance of evidence-based advice firms across the United States. He was among the first authors to publish a book that explained the science of investing in layman’s terms, The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has since written many more. His latest is Your Complete Guide to a Successful and Secure Retirement, which has been co-authored with Kevin Grogan and other colleagues at Buckingham.
If you missed Larry’s first article for TEBI last week, you can read it here: