*By Craig Lazzara*

It's commonly recognized that the average active manager underperforms the market. There are good theoretical reasons why this *should be* true, and ample empirical evidence that it *is* true. On average during the last 10 years, e.g., 59% of large-cap U.S. equity managers lagged the S&P 500, with comparably poor results for mid- and small-cap specialists.

Capitalization-weighted indices like the S&P 500 have a number of virtues, the most important of which for present purposes is that **they tell us the return of the average dollar invested**. Sharpe's conclusion that "the average actively managed dollar must underperform the average passively managed dollar, net of costs," thus explains (among other things) the results of our SPIVA scorecards.

But **cap-weighted indices do not tell us the return of the average stock**. If we want to know the average stock's performance, we can learn it by observing the return of an equal-weight index. Over time, equal-weight indices have outperformed their cap-weighted counterparts - an unsurprising result since equal-weight indices are mathematically certain to have a lower average capitalization, and there's a well-known tendency for smaller stocks to outperform larger stocks.

Now, suppose we pick stocks at random, choosing from the constituents of the S&P 500. What return should we expect? With enough trials and enough time, random selection will produce the return of the average stock in the index. That means that **the best estimate of the return of a randomly-selected portfolio is the return of an equal-weight index**.

The dozen years since we began issuing SPIVA scorecards are a period in which the equal-weight S&P 500 decisively outperformed the cap-weighted index. The underperformance of the average active manager is therefore especially striking - since the average randomly-selected portfolio would have readily outperformed. This has two implications for those who employ and evaluate active managers:

- Comparing active performance to an equal-weight benchmark can be a valuable complement to any portfolio review. Arguably,
**any alpha-generating process worth its salt should be able to outperform random selection**- which is to say, should be able to outperform an equally-weighted index. - Since most active managers haven't outperformed equal weight, it follows that, as a group,
**their performance is even worse than you think**.

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