3-to-1 Odds Favor Index Investors

by Rick Ferri

What do 25%, 25%, 25% and 25% have in common? Besides adding up to 100%, itā€™s a pattern of active fund underperformance versus indexes that consistently occurs in the mutual fund marketplace.

On average, over a five-year period, about 25% of actively managed mutual funds will outperform their benchmark, 25% of funds will underperform by a small amount, 25% will underperform by a large amount, and 25% wonā€™t make it the entire five years. 3-to-1 odds favoring index fund investing has showed up consistently over the decades and it has shown up again recently.

The year-end 2013 S&P Indices Versus Active Funds (SPIVA) U.S. Scorecard points to approximately 3-to-1 odds favoring U.S. equity index fund investors. Table 1 highlights the five-year performance of S&P indices relative to active funds. On average, from 2009 through 2013, the benchmark beat actively managed mutual funds 72.4% of the time across the three size categories as measured against comparable S&P indexes. This number accounts for 25. % of actively managed funds that didnā€™t survive the five-year period (the drop-out rate).

Table 1: Percentage of Active Funds Outperformed by the Index over five years ending 2013


Source: S&P Indices Versus Active Funds (SPIVAĀ®) U.S. Scorecard Year- End 2013. Outperformance is based upon equal weighted fund counts. All index returns used are total returns. Charts are provided for illustrative purposes.

There has always been some variance in the 25 x 4 numbers because there is a high degree of randomness in the annual performance data. Figure 1 illustrates the number of active funds outperformed by S&P indexes each year.

Figure 1: Each Calendar Year Active Funds Outperformed by the S&P Indexes


Source: S&P Indices Versus Active Funds (SPIVAĀ®) U.S. Scorecard Year- End 2013. Outperformance is based upon equal weighted fund counts. All index returns used are total returns. Charts are provided for illustrative purposes.

Thereā€™s no consistency in any style in Figure 1. On average, about 63% of actively managed funds across all U.S. equity categories underperform the S&P benchmarks over a one-year period. About 6% of funds drop out annually. The drop-outs occur when a fund company liquidates a fund or merges it into another fund. This tends to occur when there is underperformance of a fund relative to its peer group according to research on the topic, The mutual fund graveyard: An analysis of dead funds.

When stretched over a five-year period, the compounding effect of underperformance drives the number of underperforming funds higher. This is due primarily to the drop-out rate moving higher over time. In research that I conducted for my latest book, The Power of Passive Investing, I found that the percentage of active funds that failed to beat their benchmark continued to fall as the time horizon extended beyond five years and because drop-out rates marched higher over time.

There is always one or two segments of the stock and bond market where more managers outperform than underperform. In the 2013 SPIVA report, over a five-year period, those segments were international small-cap stock funds and most investment-grade U.S. bond funds. Itā€™s not possible to predict which segments of the global marketplace where more active managers will outperform over the next five years, but there will be a couple.

It doesnā€™t matter that one or more segments of active management will outperform in the future, or which segments they are, the only thing that matters is the performance of an overall portfolio. Itā€™s YOUR performance that matters!

Itā€™s my belief and the belief of other advisers who are passionate about index investing that holding a diversified portfolio of all index funds increases an investorā€™s probability for reaching their financial objectives. For details on the view, see A Case for Index Fund Portfolios that I co-authored with Alex Benke of Betterment. S&P has provided a video on our paper, Portfolio Structure: Index vs. Active.

 

 

Copyright Ā© Rick Ferri

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