Mutual fund managers blow it again

Standard & Poor's reported that "benchmark indices are outperforming actively managed funds in most U.S. equity styles year-to-date through September". The numbers aren't pretty.

As of the end of September, 62.6% of actively-managed large-cap mutual funds lagged the S&P 500 index; 57.7% of mid-cap mutual funds lagged the S&P MidCap 400 index; and a whopping 84.4% of small-cap mutual funds lagged the S&P 600 index.

Although more actively-managed funds beat the indexes in 2003, the 2004 results are consistent with longer-term trends. Over the last three years, for example, the S&P 500 outperformed 68.9% of large-cap funds, the S&P MidCap 400 outperformed 83.6% of mid-cap funds, and the S&P SmallCap 600 outperformed 78.8% of small-cap funds.

Three points to note about this:

First, these numbers are a lot worse than they seem. Many retail investors hold mutual funds in taxable accounts, but these indexes don't account for taxes. The higher portfolio churn of actively managed funds leads to annual tax bills that further reduce returns on a compounded basis. By a lot.

Second, the underperformance of small cap mutual funds is remarkable. Most portfolio managers believe that the potential for alpha generation is proportional to the effeciency of a market, and that the market for U.S small caps is less efficient than the market for U.S large caps. But active managers' failure to beat the S&P SmallCap 600 index might throw this view into question.

Why are so many active small cap managers trailing the S&P 600? Trading costs no doubt play an important role in the small cap active managers' underperformance. Spreads tend to be higher with small cap stocks, and impact costs (the movement in a stock's price when a manager buys or sells the stock) are greater. These trading costs act as a tax on active management of small cap portfolios. Another factor may be that the average market cap of stocks in many small cap funds may be smaller than the average market cap in the S&P 600, which is a relatively narrow index skewed towards larger small cap companies. The Russell 2000 is a broader index which has a lower average market cap than the S&P 600 and might be a more appropriate benchmark for small cap mutual funds. At the time of writing, the Russell 2000 is trailing the S&P 600 by about five percentage points.

Third, the large cap results are surprising for another reason. The S&P 500 index is market-cap weighted, and therefore gives far greater weight to mega-cap companies. But those stocks have tended to underperform recently, so the equal-weighted S&P 500 has outperformed the market-cap weighted S&P 500. That should have made it easier for large-cap mutual funds to outperform their index this year; but that doesn't seem to have happened.

It's not clear what the implication is for hedge funds. You could argue that these results demonstrate the difficulty of alpha generation in U.S stock markets generally. And it makes no difference if you're a mutual fund manager or hedge fund manager. Or you could argue that the higher fee structure of hedge funds attracts the best managers, so it's wrong to extrapolate from mutual fund underperformance to hedge fund underperformance.

One thing, however, is clear. Most retail investors would be far better off with index mutual funds and ETFs than actively managed mutual funds, and new products, such as Ameritrade's Amerivest ETF portfolio allocation and rebalancing account should accelerate the switch to indexing.

Links and article tools:
The press release (PDF) from S&P announcing these results is here.
This section of A Better Way to Invest discusses the underperformance of actively managed funds relative to their benchmarks in more detail.
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