Not So Pure

Jonathan Clements  |  March 12, 2016

THE LATEST MUTUAL FUND SCORECARD from S&P Dow Jones Indices had sobering news for buyers of actively managed funds: Just 17% of U.S. stock funds beat the broad market over the past 10 years. But for those who dug into the numbers, there seemed to be a glimmer of hope.

The so-called SPIVA scorecard analyzes actively managed U.S. stock funds in 13 style boxes. There are four categories for value funds, four for growth funds and four for funds that straddle these two investment styles. In each case, the four categories focus on the size of company bought: small-cap, mid-cap, large-cap and multi-cap. Thus, the SPIVA scorecard looks at small-cap growth funds, mid-cap growth funds, large-cap growth funds and so on. In addition, there’s a 13th category, devoted to real estate funds.

The failure to beat the market is flabbergasting. In 11 of the 13 categories, less than a fifth of funds managed to beat their benchmark index over the past 10 years. The worst category was large-cap growth funds, where just 6% of funds outperformed their category’s benchmark.

The best performers were large-cap value funds: 39% of these funds outperformed their benchmark index. Are value managers smarter? Is there hope for buyers of actively managed funds? I wouldn’t count on it.

At issue is a statistical quirk. Funds are almost never as pure in their investment style as the index they’re judged against. That hurts actively managed funds when their part of the market is relatively hot. Funds will often buy stocks from outside their stated area of investment focus—and these stocks will tend to drag down performance, relative to the fund’s benchmark index, when the benchmark index is on a hot streak. Conversely, when their benchmark index has weak performance, active funds often appear to be relatively strong performers, as their results get a boost from the stocks they own from outside their main investment mandate.

Sure enough, over the past 10 years, the S&P 500 Growth index was up 8.7% a year, while the S&P 500 Value index was up 5.8%. Result? If large-cap value managers snuck a few growth stocks into their portfolio, it would have helped their performance—and made them look good relative to the value index.

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