In the last few posts on the topic of Active Management, we have examined claims of two studies by major mutual fund management companies that claim to identify straight-forward criteria for selecting investment funds with a greater likelihood of outperforming their benchmark index. We have considered low cost, high manager ownership of the fund and the size or scale of the fund management firms resources (bigger is better).
Using an approach different from those of the studies’ authors, we tested their theses and conclude that neither significant manager ownership nor the size of the fund manager are valid markers. Further, the low-cost criterion, while appealing and seemingly intuitive, doesn’t really seem to bear the weight of performance marker one might expect, especially in light of the many studies that seem to confirm its value. (If you haven't yet, take a look at Parts One, Two and Three in this series to more completely understand our conclusions and methods of evaluation.)
What our evaluation does confirm is that very few active fund managers outperform their benchmarks and, by extension, their lowest cost index fund manager peers. Given the low probability of identifying superior active managers that our analysis implies, are we driven to answer “yes” to the question heading this series, Is using active investment management a fiduciary breach? It certainly begins to feel that way…except that we did notice that some fund names consistently showed up as providing often significant excess cumulative return versus the S&P 500 and Russell 1000 benchmarks as well as both peers and a well-known, low cost index fund.
So we decided to test these outperformers in a couple of ways: First, since our initial analysis ended with the 20 year period beginning 1/1/1995, we decided to evaluate how they have performed more recently, specifically for the 3, 5, 7 and 10 year periods ending 12/31/2015.
Here is what we learned:
Of 23 funds receiving a D- (64%) or better grade for outperformance in the first study, 10 (44%) also received a C or better (75% or higher) grade in the recent performance study by outperforming in at least three of the four periods measured;
The 10 funds achieving passing grades in both studies represent 13% of the original 76 funds in the multiyear study;
Five funds from the top group in the longer-term study outperformed in all of the more recent periods. Of those, four had outperformed in all 11 of the longer-term study and one in 9-of-11 periods;
Five funds from the top group in the longer-term study outperformed in three of the four more recent periods. Of those, three outperformed in all 11 periods, one in 10 periods and one in 9 of the 11 periods;
The fund fee distribution for those 10 funds was a perfect bell curve of the five lowest cost deciles: 1 of 10 funds was first (lowest) and fifth decile; 2 each were from the second and fourth decile and 4 were from the third decile.
Second, we evaluated whether and for how long the those 10 top-performing funds in both the initial study and the more recent periods’ analysis underperformed either or both of their benchmarks using annual return data from 1986 through 2015 (30 periods).
Here’s what we learned:
All of the funds underperformed in at least 40% of the periods (12 years);
The highest number of underperforming periods was 18 years or 60%;
The average number of underperforming periods was 14.5 or 48%;
The shortest consecutive period of underperformance was 2 years;
Six of the ten funds underperformed for four consecutive years;
Three of the ten underperformed one or both index for three years;
One fund underperformed the S&P 500 for five consecutive years.
It seems that although over longer periods a small number of active managers have outperformed their benchmarks, there are not clear markers for identifying them. It also seems there may not be a clear way of evaluating whether an underperforming manager is unskilled (and, therefore, not fit to manage your money) or skilled but going through an “out of favor” period.
How do we make sense of all of this? How do we answer the question of whether it’s appropriate for a fiduciary to utilize active managers?
We’ll be back with our best, although probably not fully satisfactory, answer in our next post.
Ed Lynch is founder and CEO of FPG. He has worked with ERISA-qualified plan sponsors and designated fiduciaries in most aspects of plan development and maintenance since the early 1980s. Ed founded FPG with the mission to be a leader in the field of employee benefits and the most trusted source of information and evaluation in the retirement plan industry.