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THE 19TH CENTURY feud between the Hatfields and the McCoys doesn’t hold a candle to the debate between supporters of index funds and supporters of active management.
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.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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You mention the figure of 75% underperformance over 5 years. More importantly, as the time period increases, the underperformance increases. SPIVA has only been around 15 years, after which time underperformance is in the 90% range in all asset classes. Larry Swedroe estimates by 25-30 years only about 2% of actively managed funds outperform their appropriate risk adjusted index. It really is a loser’s game.
You offer seven plausible reasons why some investors might opt for actively-managed funds. Here are some additional thoughts.
1. Probabilities
Yes, every year some actively managed funds beat the market averages. But many are like comets — they shine brightly for a while then fade away. It is well-known that the ranks of outperformers are constantly shifting. As you point out, persistence of outperformance over long periods is quite rare. Can anyone be confident that they can identify, in advance, those managers who will provide market-beating returns in the future?
2. Economic environment
Even if a crisis builds slowly, it might not be certain, at any given point, whether it has run it’s course or will continue to drive markets down. Those active managers who manage to sidestep a bear market, also must identify when it’s time to get back in. I’m not aware that active managers, in general, are particularly distinguished at identifying a market bottom. Index investors may have ridden the market down, but they will be fully invested at the bottom when the market turns. This has to be a significant advantage.
3. Risk
I’m not aware of a recent example of index investors fleeing a market downturn en masse. While we certainly can’t rule this out in the future, this may not be a significant risk if history is any guide.
It is not only indexers who crowd into the same stocks. Many active funds with similar investment styles also fish in the same pond. If I’m correct, hedge fund returns in recent years haven’t been as stellar as those enjoyed by investors in the 1980s. Today’s greater number of hedge fund managers also crowd into the same or similar investments which raises prices and reduces expected return. They could also head for the exits at the same time, exacerbating a downturn.
4. Mean reversion
Simple arithmetic tells us that all active managers as a group cannot beat the market in any given year. That’s a logical impossibility. Yes, active managers can be more nimble, but half will underperform the market regardless.
6. Yardstick
I won’t argue that there is no bias affecting the generation of SPIVA numbers. We all suffer bias to some degree. But I would argue that more important to Standard & Poors than it’s SPIVA studies is the public’s trust in it’s numbers. If the public comes to regard S&P as untrustworthy because it is perceived to be ginning the numbers for its advantage, S&P is probably doomed. Surely it’s management must understand that and try to minimize any bias affecting it’s results.
7. Priorities
If you don’t like some of the companies in the S&P 500, you don’t necessarily have to jump to active management. There are index funds that track socially-conscious ESG indexes. Vanguard’s FTSE Social Index Fund (VFTAX) is one example. It also has a 0.14% expense ratio.
Thanks for the insightful comments.
It seems to me that the passive v. active debate falls prey to the wrong point. Yes, I’m a big fan of index investing, and believe it should be the foundation of a portfolio. But the S&P 500 index is also a highly concentrated momentum fund, with the top 5 holdings responsible for 22% of the portfolio, the top 10% responsible for over 28%, and the bottom 250 responsible for just over 10%. So, if one buys an actively managed value fund to offset the momentum characteristics of the index fund, and gives up some basis points of return to do so, is that such a mistake to de-risk one’s portfolio?
Not if we know there’s a high chance of underperformance. I’d say there’s better ways to de risk your portfolio.
Excellent article. I am heavily invested in Vanguard and Fidelity index funds (IRAs and Brokerage for VG, HSA and 529s for Fido) but as I gradually move more and more to index funds, it is hard to walk away from some T. Rowe Price funds like PRWCX and PRNHX as they have handily beaten their respective indexes over 1, 3, 5, 10 and 15 years. Maybe that is why they are closed to new investors.
Excellent article, thanks for the great discussion!
I suspect that an equilibrium will develop that puts active funds at somewhere between 25 and 50% of the market. They make the market by driving the process of price discovery, and if there are not enough o them, many segments of the market would likely lose efficiency, providing an opportunity for another active fund to step in.
Index funds are free-riders in the price discovery process, and if they grow too large, if my thoughts above are accurate, opportunities will abound.
My retirement funds are largely in low cost index funds, but I do own tiny amounts of Arkk, Arkg, and Blok, not to mention some VFMF (Vanguard multi-factor).
Interesting article!
The U.S. Persistence Scorecard paints a much more discouraging record for actively managed funds than the 25% SPIVA number.
of the top-half funds of 2016, 21.4% repeated that accomplishment in 2017, with just 4.8% ranking in the top half each year through 2020. This rate is lower than what random chance would predict.
https://www.spglobal.com/spdji/en/spiva/article/us-persistence-scorecard
Anxious to learn more about direct index investing. Seems like a step forward for investors.
If you haven’t read it, you should check out Adam’s earlier article:
https://humbledollar.com/2021/07/how-to-lose-less/
I agree on Risk. For most of the past 100 years, no one invested in index funds. Now, in the past 10 years, everyone is in index funds, which have done very well. Furthermore, if you look at the structure of the S&P 500, a mere 6 high-priced tech stocks make up 30% of the portfolio, and account for nearly all of the growth. Can this continue?
One important thing about active funds is that manager’s hands are largely tied. When the market is booming, money pours in and they are forced to buy stocks that they don’t think are that great. When the market falls, redemptions come along and they are forced to sell good stocks for low prices. You can’t win this way. An individual investor managing his own account, on the other hand, can buy when the market is favorably priced.
Yes, it sounds logical to do that. In practice the data shows you are better off indexing.
Adam- Excellent!