Whether to follow an active or a passive investment approach is an argument that has been raging for a number of years. It is an argument that has increased in its intensity with the availability of thousands of retail ETFs offering easy and cheap access to passive investment styles.
The following article contains a summary of an important report released each year by S&P Dow Jones that is essential reading for anyone interested in the active versus passive debate.
But before we get to the report, a few words of introduction. The debate between passive and active management stirs strong emotions on both sides of the spectrum. When tempers get too heated I think it is always worth remembering the wonderfully sage words of the Nobel prize winner William F Sharpe when talking about the reasons to consider a passive investment approach:
In the long run, this boring approach [passive investing] can give you more time for more interesting activities such as music, art, literature, sports, and so on. And it very well may leave you with more money as well.
On a personal note, I can see the arguments on both sides of the debate. Perhaps I may have already given away my general feelings on which side of the argument I generally believe in by the headline of this article. I do believe that given the evidence, the active crowd has to make an increasingly strong and plausible argument in certain areas of the investment universe, if passive investing is not going to become the dominant approach.
I would, however, also hazard a guess that the general readership of SA probably holds different views and believe they can outperform through active investing. So this sort of article may not make me very popular! (Though I have always believed that the smarter investor is the one that reads articles and views that are contrary to their own).
Either way, if you believe that you - or your active fund pick - can outperform a benchmark, read on because this article contains some interesting data. An invaluable reference for any investor who wants to make an informed decision about the advantages and disadvantages of either a passive or active approach is an annual report produced by S&P Dow Jones. It's called, rather non-memorably, the "S&P indices versus active funds scorecard" known for short as the "SPIVA" scorecard.
The report is quite long and full of figures, so the following is my summary of the results of the annual report which I have tried to present in an easily digestible and readable form.
Domestic (US) Equity Funds
Let's start with the largest and most liquid funds - those invested in various styles and capitalizations of the US equity market.
The report breaks the funds down into sixteen different classes and measures them against their respective benchmarks.
The graph below shows how many of the funds in each class outperformed their respective benchmark in 2012. (All data in this article is taken from the SPIVA Scorecard - 2012 year-end report).
Perhaps the shock of this information will mean the picture above isn't very clear for some dedicated active equity investors. I'll try and make it clearer. In 2012, out of 16 equity classes, in only two categories (those shown in yellow - Real Estate and Large Cap Growth) would you have had a greater than 50% probability of selecting a fund that outperformed its benchmark. And in both those cases, the probability would have only been a touch over 50%.
In case that's not gloomy enough reading for the die-hard active investors out there, the following presents the same information, but over a three year investment horizon.
The results are rather staggering - in the best-performing fund category the investor would have had only a 22.4% probability of selecting an active fund that outperformed its benchmark. This was the best! Have a look at the worst performing category - a mid-cap growth investor who selected an active fund would have had a 5.8% (five point eight percentage!) probability of selecting a fund that outperformed its benchmark.
Just before the active investment world hangs up its boots on reading this article (which I doubt is the case) let's turn to some (slightly) more optimistic news.
International Equity Funds
Out of the four international equity fund categories that the report examines, the good news is that in 2012 you would have had a better than odds-on chance of picking a 'winning' fund (i.e. an active fund that outperformed its benchmark) in three out of the four categories.
As the graph shows - the chances of picking an international small-cap fund that outperformed its benchmark was, at 85%, actually pretty impressive. And two other categories would have also given you a greater than 50% chance of picking a fund that outperformed its benchmark.
So, is that case closed for active management on international funds being the way forward? Well, not quite. The bad news is that over a three year horizon, only international small-cap funds would have given you a better than 50% chance of choosing a fund that outperformed its benchmark (with an impressive 90% of funds giving you a performance that out-stripped the benchmark). But with all three of the other categories we are back down to below a 50% chance.
Perhaps not surprisingly, the picture for active investors is slightly more optimistic with active fixed income funds comparing relatively favorably to that of active equity funds.
The table below shows the percentage of active fixed income funds that beat their benchmark in 2012, across different categories of the fixed income universe. The picture is remarkably rosy (especially after seeing how badly active equity managers perform). In all the fund categories shown in yellow, the investor would have had a greater than 50% chance of the fund beating its benchmark. An impressive four categories - Munis, MBS, Global and Investment Grade Intermediate Duration - had a very respectable plus-70% chance of beating their respective benchmark.
The picture changes slightly with a three year view - though there is still room to be supportive of active investments in certain categories. Two of the categories that had given the investor a sporting chance (over 50%) of beating the benchmark over one year have now dropped to below 50% for a three year horizon.
But perhaps what stands out is the performance of the bottom three categories and how quite remarkably bad it is. Only 2.2% (two point two percentage!) of active investment grade long duration fixed income funds outperformed their benchmark over the previous three years.
So the debate is not a clear cut one. It would appear from this study that more active management opportunities are available in the fixed income space than in equities. And there are definitely areas where active investment seems to have a very significant and meaningful advantage over passive investing.
But I still find it hard to counter the argument that overall the passive investor in liquid transparent markets (perhaps almost any equity class), will not on balance end up outperforming the active investor. What if I'm wrong? Well, as William F Sharpe said, at least I would have had some extra time for playing some tennis along the way.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.