Spotlight On Performance

Active investment management – any strategy intended to beat the performance of its index benchmark – has been under scrutiny for decades for its inconsistency in delivering on its objective. There is plenty of anecdotal evidence that some active managers do very well and some of those surely are doing well. However, numerous studies over the years, using scientific methodology, have all basically come to the same conclusion:

There is little or no evidence that active managers can outperform market index returns over sustained periods of time, other than through luck.

The index benchmarks have proven to be a very difficult hurdle; in fact, over the past 10 years, only 9% of Canadian equity managers beat the index benchmark. [1] Among managers of US equity, less than 2% beat the index benchmark. Less than 10% of international equity managers beat their benchmark over 5 years (no data was available for 10 years). What’s worse is the fact that there is no evidence that even those managers that do beat the markets on a regular basis are skillful. [2] To use an analogy, the probability of getting at least 8 heads when tossing a coin 10 times is about 5%. Would we say that these people are skilled at tossing coins and the other 95% are unskilled? Of course not. Incidentally, the 5% figure is not far out of line with the fraction of managers whose performance really does stand out over any given period.

Past performance data is often skewed with survivorship bias – the tendency for underperformers to drop out of performance surveys. Participation in comparative performance surveys is always voluntary, so managers that do not perform well tend to withdraw their participation to avoid scrutiny. When this happens, it makes all of the Darwinian survivors look better than they really are, as the average return of the group increases; of course, the index benchmark remains the same because it represents the sum of ALL investors’ performance – not just the survivors. Scientific studies, like the one reference here, show that once you adjust for survivorship bias, professional active managers have not performed up to their own expectations since around the 1960’s; a time when there were far fewer investment experts sifting through publicly available information, and computer technology was still in its infancy.

The markets have become more efficient. So why do so few active managers succeed? It’s mostly because of fees and trading costs, but a lack of discipline is likely another culprit.

Indexed investment management – any strategy intended to closely track the performance of its index benchmark – has proven to be an extremely effective long-term strategy for both retail and institutional investors alike. Hence, we have witnessed an impressive shift, globally, from active management to indexing as investors increasingly catch on to indexing’s compelling advantages. This movement has been growing for many decades and recently has become popularized with the use of exchange-traded funds (ETFs), which allow retail investors to gain index exposure directly, at very low cost.

[1] S&P Dow Jones Indices. SPIVA Canada Scorecard Year-End 2016
[2] Luck versus Skill in the Cross-Section of Mutual Fund Returns by Eugene F. Fama and Kenneth R. French, Journal of Finance, September 2010.

“Perhaps there really are managers who can outperform the market consistently – logic would suggest that they exist. But they are remarkably well-hidden”.
– Paul Samuelson, Ph.D., Nobel Laureate, Economics (in Journal of Portfolio Management, 1974)