Bear Mountain Capital Inc.

Index Funds or Active Management?

| June 21, 2012

Portfolio Management

Did you know that most active equity mutual fund managers under perform their peer benchmarks over time?  As the time period stretches past 10, 15 or 20 years, the amount of under performance can be staggering.

Under-Performance in US Equities

According to data compiled by The Vanguard Group (Phillips, Christopher. “The case for indexing.” Valley Forge, PA: The Vanguard Group, 2012.) the percentage of actively managed US equity funds that under-performed their respective market benchmark over 15 years, as of December 31, 2011 was impressive:
* If you were a large-cap blend investor, nearly 64% of all actively managed large-cap blend funds you could choose from for this time period underperformed their benchmark
* For mid-cap blend investors the numbers were more dire, nearly 93% of all active funds in this space underperformed their benchmark.
* Small-cap blend investors didn’t fare much better, they underperformed as a group by 91%.

Survivorship Bias

The above numbers do not account for  “survivorship bias”.  In other words, the above numbers include all funds that are still in existence as of December 31, 2011 and have not closed their doors due to poor performance.  However, if you factor back-in the actively managed fund returns for mutual funds that went out of business during this 15 year period, the numbers look even worse:
* For large-cap blend investors, under-performance jumped to 84% from 69% when factoring in survivorship bias.
* Mid-cap blend investors under-performance moved up to 96% of all actively managed funds in this space, from 93%.
* Small-cap blend investors saw their under-performance percentages go up to 95% from 91%.

International Developed Equity

The above numbers do not fare well for active stock fund managers that invest in US equities.  The story on the international side is not much different:
* At first glance, 35% of actively managed funds in the international developed equity markets under performed, but when you factor in survivorship bias, its closer to 61%.
* Additionally, many international developed equity funds had significant exposure to emerging markets stocks.  Emerging market stocks heavily outperformed the international developed equity asset class, resulting in skewed returns for the actively managed international developed equity class as a group.

All-in-all, according to the study, the worst performing actively managed funds were in the mid-cap value space (100% underperformed the S&P Mid-Cap Value Index), while the best performing actively managed funds were in the large-cap value space (57% underperformed the S&P 500 index).

Fixed Income

You might think that active bond managers did better than active stock fund managers when it came to under or out-performance.  It turns out, that the numbers are even worse for bond/fixed income managers during this time period:
* Corporate fixed income fund managers under-performed by 98% and 99% when factoring in survivorship bias
* High-yield fixed income


What is the point of all this?  Trying to pick stocks, as an amateur or as a professional is not a successful long-term endeavor for most people or institutions.  For those that do outperform over extended periods, the amount of out-performance is usually incremental and not enough to justify the risks of the manager making bad decisions (ie, under-performing their respective index).

What should you do?  No matter what your risk tolerance is, be sure that index funds (equity or fixed income) make up the bulk of  your exposure to the asset classes you desire to have in your portfolio.  Investing in index funds have the following advantages:
* Index funds are built to specifically track their respective index.  This means an investor can be assured of returns that will be as close to the market over time, as possible.
* Index funds are passively managed funds.  They do NOT employ teams of researchers and active managers to make decisions, this results in lower fees and expenses and higher returns to investors.
* Index funds are tax-efficient, many index funds trade on an exchange, so investors can redeem their shares in an index fund without forcing a fund manager to realize capital gains for all investors, this saves on taxes and results in higher returns to all investors in the index fund.

If you have questions about this strategy, or would additional information, please give me a call or send me an e-mail.