Yes, Fund Managers Really Do Underperform

Last summer, Baruch, Zubin, and I got into a discussion about the oft-cited statistic that 75% of fund managers underperform their benchmark. Is it true? Baruch concluded that no one really knows where it came from: "it seems the 75% rule will remain unattributable," he said.

But now there's an empirical study out:

Standard & Poor's Index Services has relaunched its Spiva scorecard, which compares the performance of US mutual funds and benchmark indices. Using data corrected for survivorship bias, the scorecard shows the benchmarks outperformed the managers in at least 70 per cent of cases in almost all categories.

"This is true even in relatively inefficient segments of the market such as small capitalisation stocks and emerging markets," said Srikant Dash, head of global research and design at S&P Index Services.

Here, for instance, is the US scorecard for mid-2008:

Over five years ending June 2008, S&P 500 outperformed 68.6% of actively managed large cap funds, S&P MidCap 400 outperformed 75.9% of mid cap funds and S&P SmallCap 600 outperformed 77.8% of small cap funds.

What's more, the fund performance figures do take into account annual fees, but they don't take into account any up-front "loads" -- the fee paid by investors to get into the fund in the first place, which can be as high as 5%.

Interestingly, in a case of creative destruction, the new, improved Spiva rose from the ashes of the dismembered old Spiva:

SPIVA has been a popular keeper of statistics on the active versus passive debate for more than five years. Till first quarter of 2007, it was based upon the S&P Mutual Fund database, a continuous, consistent, survivorship-bias free database. In 2007, that database lost much of its continuity and consistency following its sale and restructuring. Therefore, we had to seek alternative data sources to which we could apply the SPIVA methodology.

The new database, put together with combining data from the Center for Research in Security Prices with Lipper fund data, includes more than 3,500 fund portfolios. Which I think makes it the last word on this discussion, at least for the foreseeable future.

(HT: Alea)

Comments

[Robert Nabloid:]

Of course mutual fund managers under-perform. Due to diversification rules, most mutual funds are so diversified they are statistically linked to the market average - so most will be fairly close to the market average (a little better or a little worse). Then you must factor in fees. Presto, most are doing worse than the S&P.

I'd be willing to bet that if mutual funds didn't have to follow the diversification rules and many of them held less than 10 stocks, a lot more would outperform the S&P and a lot more would under-perform it, but by greater amounts in either direction. So the diversification rules might protect people a bit from losing a lot - but it also ties the hands of most mutual fund managers from being able to greatly outperform by a lot.

2008 Nov 18 05:49 PM

[Robert Nabloid:]

Of course mutual fund managers under-perform. Due to diversification rules, most mutual funds are so diversified they are statistically linked to the market average - so most will be fairly close to the market average (a little better or a little worse). Then you must factor in fees. Presto, most are doing worse than the S&P.

I'd be willing to bet that if mutual funds didn't have to follow the diversification rules and many of them held less than 10 stocks, a lot more would outperform the S&P and a lot more would under-perform it, but by greater amounts in either direction. So the diversification rules might protect people a bit from losing a lot - but it also ties the hands of most mutual fund managers from being able to greatly outperform by a lot.

2008 Nov 18 05:49 PM

[Alex Filonov:]

Fund managers have no incentive to perform. They take fee as a percentage of managed money. Fund performance doesn't matter, and sometimes the kill it using "window dressing", just to show the latest "performing" asset in the portfolio by the end of quarter. I bet lots of fund will show maximum cash allowed in their portfolios in the end of this quarter.

2008 Nov 18 10:30 PM

[venividivici:]

Diversification is the killer. The most common advice you get from so called "financial experts and advisors"is to diversify and it is supurb advice as long as you want to go nowhere. Everything just evens out and you end up never making any real money. You need to know what you're doing so you can pick winners and then you need the balls to go for it with everything you've got. Most fund managers don't have these attributes but they don't need them. They have big fat fees to fall back on. It is very very unlikely that you will ever get rich relying on others for investment advice. You have to learn to do things for yourself.

2008 Nov 18 11:14 PM

[Reggie Midd...:]

It is nearly impossible for long only equity fund managers to diversify in this market, since nearly all equities have practically been moving in unison. In addition, diversification does not necessarily reduce risk Finally, beating a benchmark is useless industry speak, investors want to make money, not beat a benchmark. You could have beat the S&P this year and have lost your clients nearly half of their money. With friends like those, who needs enemies.

For those who really think that beating a benchmark means anything and cannot be done regularly (efficient market adherents), I have beat the market every year I have invested while assuming much less risk. This year I have killed it: see boombustblog.com/index...

2008 Nov 19 08:52 AM

[Smarty_Pants:]

If you changed the fee structure you could probably improve fund performance. Pay the managing employees a modest salary, cover the trading expenses, and then reward them with 20% of any gains above the respective index performance. (Note that's GAINS. If they lose money and still beat the index they get nothing extra.) Let the funds pay for their own research resources and overhead, or charge a fixed fee annually for a modest overhead.

Remove the % of funds held pay schedule and instead pay for costs plus performance above the benchmark. This puts the incentive in the proper place for manager self-interest to motivate better fund performance.

2008 Nov 19 09:59 AM