The Disillusion of Confidence
Written by Krisna Patel, CFA and edited by Hanna Jackson
It comes as no surprise that investors expect financial advisors to be able to select profitable and suitable investments for client portfolios. There are three primary ways in which advisors approach this decision-making process. Some advisors rely on their home office or investment companies to perform the research and create a list of recommended investments. Others prefer to leave the investment decisions and asset management solely in the hands of a third party. Lastly, an advisor may prefer to perform their own research and analysis to determine suitable investments for their clients.
As an advisor who enjoys the research and analysis approach, I have begun to wonder if the time spent on choosing between active and passive management, especially with large-cap blend funds, is worth the trouble. Many different studies are available to argue the success of one over the other, and each strategy certainly has its pros and cons. I do not intend to elaborate on these differences; instead, I am presenting data I have gathered over the years for advisors and investors to bear in mind when deciding between active and passive investments.
Standard & Poor’s®—one of the world’s largest indexers—publishes a semi-annual report called the SPIVA® Scorecard[i]. The Scorecard shows current and historical data relating to the success of active mutual funds as compared to their respective benchmarks. I’ve been keeping up with these reports since 2013, and the consistency of S&P’s findings is noteworthy: most active managers are unable to beat their stated benchmarks. In fact, most benchmarks see over 70% of the corresponding funds underperform. For example, 79.39% of large-cap core funds in 2013 failed to outperform the S&P 500 over the previous five years[ii]. By mid-2018, that number had increased to 88.1% of large-cap funds underperforming[iii]. Increasing the time frame from five to ten years, 94.01% of those funds trailed the benchmark.
To verify that the S&P has not glamorized their reports with a bias against active management, I consulted the Morningstar® Active/Passive Barometer[iv]. This semi-annual report gauges the success of active funds against their passive counterparts by compiling data from thousands of U.S. funds. The 2018 year-end report, with evaluations from approximately 4600 funds, affirms that 16.4% of managers outperformed their respective ETF benchmarks on a five-year basis and a mere 10.9% on a ten-year basis.
This disconcerting data raises the obvious question: why spend the time and energy to find the best actively managed funds? I believe there are two common responses to this question, but both come with a counter-argument supported by further data analysis.
The first reply involves the chances of success indicated by the SPIVA® Scorecard. The mid-2018 SPIVA® report previously mentioned 11.9% of large cap funds beat the S&P 500 over the five-year period. In an ideal situation, it would be possible to isolate those successful funds ahead of time, right? The issue with this optimistic thinking, though, is laid out in a second report published by Standard & Poor’s®—the Persistence Scorecard.
The S&P Persistence Scorecard delves deeper into the active-fund data, looking at each fund’s historical performance from period to period. Each fund category (e.g. domestic small cap, emerging markets) is divided into quarters to measure how well each fund continued to perform over a set time period. Essentially, did the top quartile of funds consistently remain in the top quartile, giving advisors the chance to predict the most successful funds? The research reveals a resounding no. As an example, 21.36% of all large-cap funds in the top quartile in September of 2014 remained so in September 2015[v]. By September 2018, 0.91%--yes, less than 1%--of those funds were still in the top quartile. That means, out of 220 large-cap funds in September 2014, only 2 funds remained in the first quartile in September 2018. Clearly, using historical fund performance to accurately determine future outperformance is near impossible.
The second argument for seeking the best active funds is about optimizing the risk-return tradeoff, and this is where risk analyses like the Sharpe and Sortino Ratios come into play. Both ratios calculate how well an investment’s return compensates for its volatility. The higher the ratio, the more enticing the investment becomes.
To assess the advantage of using these risk measures to determine the most lucrative funds, I utilized Morningstar® Advisor Workstation to screen for Institutional and no-load share classes of large-cap core funds with an inception date on or before 01/31/2009[vi]. Of the resulting 237 individual funds, a mere 22 had a higher Sharpe Ratio than iShares® Core S&P 500 (IVV) on a ten-year basis. Removing the two index funds, a total of 20 actively-managed funds (8.44%) beat the iShares’ Sharpe Ratio. Likewise, only 34 funds (14.35%) had a higher Sortino Ratio than the iShares® ETF on the ten-year basis. The notion that actively managed funds have a higher chance of providing a better risk/reward profile over the long run is categorically inaccurate.
The tendency of investors and advisors to select Large-Cap Core active funds based primarily on risk and/or past performance in comparison to a standard S&P 500 ETF is insufficient and will likely lead to disappointing results. In such cases, selecting a low-cost ETF that tracks an index would be ideal.
There may be cases in which active management can provide alpha or risk reduction in certain asset classes, warranting additional research. It may also be worthwhile selecting an active fund in order to target a specific return or risk profile. For instance, an investor may find an active manager that fits the mandate of a particular income or return stream. Similarly, a desire for stability within a certain asset class may be met by an active manager who targets lower volatility.
In short, advisors and investors who overestimate their ability to choose superior large-cap asset managers (a bias tendency known as the Overconfidence Effect) are concentrating on an ineffective means to the end of successful investing. True confidence in selecting suitable active or passive funds is found by focusing, not solely on past performance and risk, but on the end goal.
Edited by Hanna Jackson, non-registered assistant to Krisna Patel
Past performance is not a guarantee of future results. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of 02/08/2019, based on the information available at that time, and may change based on market and other conditions. Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.
Krisna Patel is an Investment Advisor Representative at Engage Financial Group--11622 North Michigan Road, Zionsville, IN 46077.
Securities and investment advisory services offered through Woodbury Financial Services, Inc. (WFS), member FINRA/SIPC. WFS is separately owned and other entities and/or marketing names, products or services referenced here are independent of WFS.
[i] S&P Dow Jones Indices SPIVA® U.S. Scorecard. Published on https://us.spindices.com/spiva.
[ii] S&P Dow Jones Indices SPIVA® U.S. Scorecard, year-end 2013. Published on https://us.spindices.com 03/20/2014.
[iii] S&P Dow Jones Indices SPIVA® U.S. Scorecard, mid-year 2018. Published on https://us.spindices.com 10/17/2018.
[iv] Morningstar’s Active/Passive Barometer, February 2019. Published on https://www.morningstar.com/lp/active-passive-barometer 02/07/2019.
[v] S&P Dow Jones Indices Persistence Scorecard, September 2018. Published on https://us.spindices.com 12/11/2018.
[vi] Source: Morningstar® Advisor Workstation. Data as of 01/31/2019.