To answer the question "When it comes to active management, is the past prologue?" the S&P Indices Versus Active scorecard (SPIVA), released twice per year, tracks the consistency of top performers over yearly consecutive periods and measures performance persistence. As sure as the sun rising in the east, the answer is the same - the persistence of outperformance is about what should be randomly expected. Thus, investors cannot use past performance to identify in advance which of the active funds will outperform in the future.
The September 2013 report, just released, report produced the following findings, findings which are virtually the same from year to year:
- Very few funds consistently stay at the top. And as the time horizon increases, the performance persistence of top quartile funds declines. Of the 692 funds that were in the top quartile as of September 2011, only 7.2 percent were still the top quartile two years later, about 1 percent more than would be randomly expected. The results weren't much different when broken down by market cap. 5.2 percent of the large-cap funds, 10.3 percent of the mid-cap funds and 8.2 percent of the small-cap funds remained in the top quartile.
- For the three years ended September 2013, 19.3 percent of large-cap funds, 20.1 percent of mid-cap funds and 26.8 percent of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. Only small-cap funds managed to exceed the 25 percent that would be randomly expected to do so.
- Similar results are produced when the horizon is extended to five years where random expectations are for a repeat rate of 6.25 percent. For large-cap, mid-cap and small-cap funds the repeat rates were 7.7 percent, 0.9 percent, and 9.9 percent respectively.
- The one place we do see consistency of performance beyond the randomly expected is in the bottom quartile where high costs are generally the culprit. The poor performance results in the merger or liquidation of many funds - which is why it's so important to be sure that the data being studied is free of survivorship bias.
Bradford Cornell, professor of financial economics at the California Institute of Technology, observed in his study "Luck, Skill, and Investment Performance," that "Successful investing, like most activities in life, is based on a combination of skill and serendipity. Distinguishing between the two is critical for forward-looking decision-making because skill is relatively permanent while serendipity, or luck, by definition is not. An investment manager who is skillful this year, presumably will be skillful next year. An investment manager who was lucky this year, is no more likely to be lucky next year than any other manager." The problem is that skill and luck are not independently observable."
Since skill and luck are not directly observable we are left with observing performance. In his study , Cornell found that the great majority (92 percent) of the cross-sectional variation in fund performance is due to random noise. This result demonstrates that "most of the annual variation in performance is due to luck, not skill." He concluded: "The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill."
Professors Eugene Fama and Ken French also studied this topic in their paper "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates." They found that active managers as a group have not added any value over appropriate passive benchmarks. They concluded: "For (active) fund investors the simulation results are disheartening." They did concede that the results look better when looking at gross returns - the returns without the expense ratio included. However gross returns are irrelevant to investors unless they can find an active manager willing to work for free.
Summarizing, the persistence of the evidence from academic papers, along with the evidence presented by the S&P twice-yearly scorecards, is surely contributing to the trend away from active management. Today, more than $3 trillion is invested in index strategies. In the meantime, active investors are engaging in a massive transfer of wealth. Professor Ken French, in his 2008 paper, "The Costs of Active Investing," estimated that active investing led to the transfer of about $80 billion annually from wallets of investors to the wallets of the purveyors of active management strategies. Given the increase in total market capitalization since 2008, that figure is now much higher. And despite the enormity of the costs, French's estimate is too low. The reason is that it does not take into account the incremental burden of higher taxes incurred by active investors with taxable holdings.
I will point out that the cost of active investing is not a pure loss to society - the price discovery activities of active managers improves the accuracy of financial prices and allows for an efficient allocation of capital. The good news for passive investors is that they get to be "free riders," benefiting from the activities of active managers without paying the costs.