Those in the index fund camp cite decades of data—going back to the 1930s—to support their view that active management is a fool’s errand. In fact, Standard & Poor’s regularly publishes a study it calls SPIVA, short for S&P Index Versus Active. Each time, analysts there reach the same conclusion—that it’s exceedingly difficult for an actively managed fund to beat its benchmark. As an example, on SPIVA’s website today, it reports that 75% of large-cap funds have underperformed the S&P 500 over the past five years.
Largely because of this data, actively managed funds have been losing assets to their index fund competitors. Still, despite the data, many investors aren’t convinced, and it isn’t just a fringe element. The active management business remains huge, with trillions of dollars under management. Is it possible that so many investors are unaware of the long odds against them?
That may be true in some cases, but that isn’t the whole story. There are actually quite a few reasons people still support active management. Even if you remain on the index side of the fence—like me—I think it’s useful to understand why others see things differently. Below are seven common arguments:
1. Probabilities. Yes, the odds are long. But many investors who choose active funds understand that there’s a difference between low probability and zero probability. Even if the SPIVA numbers say that 75% of funds underperform their benchmarks, that still means that 25%—one out of four—outperform. Put that way, it doesn’t seem as crazy to seek out a fund with high potential. Moreover, that 75% figure isn’t uniform across all fund categories. There are several categories in which the odds are much better. In fact, a majority of actively managed funds have outperformed in some categories over the most recent five-year period. Also, that 75% doesn’t apply to every time period. It varies considerably from year to year.
2. Economic environment. Index funds are designed to track the market. That’s great—until the market drops. For that reason, many believe that active management pays off during bear markets. The logic here makes sense. When the market drops, index funds simply drop in lockstep. But an active manager has the opportunity to take evasive action. That’s because most crises build slowly. Even when the market has dropped 50%—as it’s done several times—it’s never happened overnight. Active managers have a window to respond before a crisis gets worse. Sound reasonable? Unfortunately, the data don’t back this up. Active funds have underperformed during many stock market downturns, including 2008 and 2020.
3. Risk. Some investors see risks in the structure of index funds. Michael Burry, famous for predicting the 2008 mortgage bond crash, believes that index funds are a ticking time bomb. That’s because they buy mostly the same stocks. He uses the analogy of a crowded movie theater, with this ominous warning: “The theater keeps getting more crowded, but the exit door is the same as it always was.” He adds, “The longer it goes on, the worse the crash will be.”
Is Burry right? That’s the tricky thing. No one can say. It was only two years ago that index funds surpassed actively managed funds in total assets. We’re in uncharted territory, and he might end up being right. I happen to disagree, but no one can say with certainty that something that hasn’t happened before won’t happen in the future.
4. Mean reversion. In the investment world, it’s common to talk about reversion to the mean. The idea is that things that are far above or below average won’t stay that way forever. It’s possible this could occur with mutual funds. No one can say for sure what might make active funds shake off their slumber, but I’ve heard a handful of theories. The one that makes the most sense: Active managers are more nimble and could gain an advantage as more dollars go into index funds, which just passively mimic the market.
5. Personality. When Gallup asks Americans what they think of Congress, approval ratings generally fall in the 30% range—not very good. But ask Americans what they think of their own representative, and a majority approve. It’s the same, I think, with mutual fund managers.
Sure, the SPIVA numbers might say that actively managed funds underperform on average. But when investors search for actively managed funds, they aren’t looking for average. Rather, they’re looking for stars—and they believe they can identify them. If a fund manager has a strong track record, that helps. If the fund manager has a strong personality, that helps even more.
While index funds are largely driven by computers, active funds have public faces. Some managers become quite well known. In the 1980s, it was Peter Lynch, who ran Fidelity Magellan Fund with amazing success and authored several books. In the 1990s, it was Bill Miller, whose fund once beat the S&P 500 for 15 straight years. Today’s biggest star may be Will Danoff, the longtime manager of Fidelity Contrafund. When investors put money into these funds, they’re betting on the fund manager’s brilliance. The SPIVA numbers, I suspect, aren’t even a consideration.
6. Yardstick. One of the criticisms of the SPIVA numbers is that Standard & Poor’s has an inherent bias. It earns millions licensing its indexes—the S&P 500, for example—to index fund companies. Because of that perceived bias, some have criticized the methodology that S&P uses in its SPIVA studies. I don’t find these criticisms compelling. But it’s important to note that when S&P compiles its data, it does have an interest in the outcome.
7. Priorities. As I often say, there are two answers to every question in personal finance: There’s the quantitative answer—and then there’s the “how do you feel about it” answer. If you look only at the numbers, index funds definitely score well. But for some investors, that isn’t the most important thing.
As I noted a few weeks ago, direct indexing has been growing in popularity. A large part of that, I think, is driven by investors who want the advantages of an index fund but hate the idea that indexes like the S&P 500 include tobacco and other distasteful kinds of companies. That’s another reason an investor might choose to go with active management.
When I was a kid, there was an exhibit at the local science museum. It was a model of a giant housefly—maybe two feet high. Attached to the exhibit was an explanation that a fly of this size would be physically impossible. I always found that interesting—that things don’t scale linearly, and that something that might work when it’s small might collapse under its own weight if it got larger. I’m still very much in the index fund camp, and so far I think they’re the best investment for most investors most of the time. But I always try to keep that exhibit in mind—because it stands to reason that nothing lasts forever.