By LARRY SWEDROE
The 1973 publication of Burton Malkiel’s “A Random Walk Down Wall Street” set off a revolution. Malkiel presented findings from academic research on the failure of actively managed funds to beat the market. The standard response at the time was, “So what, you can’t buy an index fund.” That was true until John Bogle came along.
Bogle graduated from Princeton in 1951. His senior thesis was entitled: “Mutual Funds can make no claims to superiority over the market averages.” In his 2010 book Don’t Count On It, Bogle recounted that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson’s 1974 paper Challenge to Judgment; Charles Ellis’ 1975 study The Loser’s Game; and Al Ehrbar’s 1975 Fortune magazine article on indexing. In 1974, Bogle founded the Vanguard Group, now the largest mutual fund company in the United States. He started the First Index Investment Trust, later renamed the Vanguard 500 Index Fund, in December 1975. The following June, a very prescient story appeared in Fortune: “Index Funds: An Idea Whose Time is Coming”. It concluded: “Index funds now threaten to reshape the entire world of money management.”
Philosopher Arthur Schopenhauer said that all great ideas go through three stages. In the first stage, they are ridiculed. In the second stage, they are strongly opposed. In the third stage, they are considered to be self-evident. This was certainly the case for Bogle’s experiment. When it was launched, his index fund was heavily derided by the mutual fund industry. The fund was even described as “un-American,” and it inspired a widely circulated poster showing Uncle Sam calling on the world to “Help Stamp Out Index Funds.” The fund was lampooned as “Bogle’s Folly”.
Fidelity’s chairman, Edward Johnson, assured the world that the company had no intention of following Bogle into index funds when he stated: “I can’t believe that the great mass of investors are going to be satisfied with receiving just average returns. The name of the game is to be the best.” Another fund manager, National Securities and Research Corp., categorically rejected the idea of settling for average. “Who wants to be operated on by an average surgeon?” they asked. And that refrain — that indexing and structured investments in general will get you only average returns — became one of the big lies told by Wall Street. Consider the following evidence from Standard & Poors.
The data doesn’t lie
Since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) Scorecard, which compares the performance of actively managed equity mutual funds to their appropriate index benchmarks. The 2019 Mid-Year Scorecard includes 15 years of data. Following are some of its highlights:
• Over the 15-year period ending June 2019, 90 percent of large-cap, mid-cap and small-cap funds underperformed their benchmark S&P indices. In only one asset class, large value (80 percent underperformed), was the percentage of underperformers below 86 percent.
• Over the 15-year period, on an equal-weighted (asset-weighted) basis, the average actively managed U.S. equity fund underperformed by 1.4 percent (0.74 percent) per annum. The worst performances were small caps, with active small-cap growth managers underperforming on an equal-weighted (asset-weighted) basis by 1.99 percent (0.90 percent) per annum, active small-cap core managers underperforming by 2.43 percent (1.82 percent) per annum, and active small–value managers underperforming by 2.00 percent (1.71 percent) per annum. This exposes another of the myths Wall Street tried to perpetuate—the small-cap asset class is inefficient and active management is the winning strategy.
• Over the 15-year period, across all international equity categories, a large majority of active managers underperformed their respective benchmarks. For example, 82 percent of active global funds underperformed, 90 percent of international funds underperformed, 73 percent of international small-cap funds underperformed, and in the supposedly inefficient emerging markets, 94 percent of active funds underperformed.
• Over the 15-year period, on an equal-weighted (asset-weighted) basis, active global funds underperformed by 1.32 percent (0.36 percent) per annum, active international funds underperformed by 1.83 percent (0.68 percent) per annum, and active emerging market funds produced the worst performance, underperforming by 2.34 percent (1.09 percent) per annum. And while on an equal-weighted basis international small-cap funds underperformed by 0.70 percent, on an asset-weighted basis they managed to slightly outperform (+0.19 percent).
• The performance in fixed-income funds was also poor. Over the 15-year period, in none of the 14 categories did the majority outperform. Fewer than 82 percent underperformed in only three cases, more than 90 percent underperformed in five cases, and 99 percent underperformed in high-yield funds, the worst-performing category. On an equal-weighted basis, the underperformance ranged from 0.1 percent (global fixed-income funds) to as much as 3.46 percent (government long-term funds). The news was better on an asset-weighted basis, with active funds outperforming in three categories: investment-grade intermediate-term (0.37 percent), investment-grade short-term (0.37 percent) and global income (0.89 percent). In the other 11 categories, the worst performances were in long-term government (refuting the claim that active managers can time bond markets), underperforming by 2.89 percent; long-term investment grade, underperforming by 2.3 percent; and high yield, underperforming by 1.51 percent.
• Highlighting the importance of accounting for survivorship bias, over the 15-year period, 57 percent of domestic equity funds, 49 percent of international equity funds, and 52 percent of all fixed-income funds were merged or liquidated.
It is also important to note that the rankings are based on pretax returns. In most cases, index and other structured funds will be more tax efficient due to their typically lower turnover. And exchange-traded fund (ETF) versions would further enhance the tax efficiency of index funds.
What about bear markets?
With the sharp drop in the bear market we have experienced since the last week of February 2020, some might be wondering if, while indexing outperforms over the long term, perhaps active managers protect you from bear markets. I addressed that question in my April 21, 2009, column for cbsnews.com. One study I cited was from Vanguard’s research team. It appeared in the Spring/Summer 2009 issue of “Vanguard Investment Perspectives.” Defining a bear market as a loss of at least ten percent, the study covered the period 1970-2008. The period included seven bear markets in the U.S. and six in Europe. Once adjusting for risk (exposure to different asset classes), Vanguard reached the conclusion that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome”. They also confirmed that “past success in overcoming this hurdle does not ensure future success.” Vanguard was able to reach this conclusion despite the fact that the data was biased in favor of active managers because it contained survivorship bias.
The only really surprising fact is that the myth that active management outperforms in bear markets persists. Long ago, William Sharpe demonstrated that anyone who can do simple arithmetic can understand that regardless of the asset class or whether there is a bull or bear market, in aggregate active managers must underperform simply because they have greater costs.
Given the evidence, it is pretty clear that structured funds don’t get you average returns. They provide investors with market returns of the asset classes in which they invest, and by doing so at low costs, they produce above-average returns for their investors.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
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