In this book, author Larry E. Swedroe makes a strong case for passive investing (that is, investing in low-cost exchange traded funds and index funds) and against actively-managed funds (funds that are managed by fund managers). He has marshalled an impressive array of facts and figures to support his argument.
On an average, he says, actively-managed funds in the US have underperformed their benchmarks on a pre-tax basis by about 1.8 per cent (he does not cite the period). On a post-tax basis, their returns are even poorer. Further, there is no persistence in their performance beyond that which would be randomly expected. Hence, past performance is a poor predictor of future performance.
According to the author, the laws of mathematics dictate that actively-managed funds must in aggregate underperform passively-managed funds. He gives a mathematical example. Suppose that 70 per cent investors in a market are active investors and 30 per cent are passive investors. Suppose also that the market gives an overall return of 15 per cent. Then on a pre-expense basis the passive investors will also earn a 15 per cent return. What returns will the active investors earn? If the returns earned by active investors is X per cent, then the following equation represents what they will earn:
15% (100%) = x% (70%) + 15% (30% )
15% = 0.007x + 0.045
x = 15%
Thus, at the aggregate level, on a pre-expense basis, active investors will also earn the same rate of return as passive investors. But thereafter their high expenses drag their net returns lower. Thus, he says, what makes active management a loser's game in aggregate is higher cost.
Higher costs
What are the costs that an actively-managed fund incurs? Firstly, actively-managed funds' expense ratio is much higher than that of passively-managed funds.
In their operation, actively-managed funds incur several other costs that passively managed funds either don't incur or incur a lot less. Active funds churn their portfolios more than passive funds, so they incur higher trading costs. Trading cost tends to be higher in the small-cap space (due to a higher bid-offer spread on account of lower liquidity) than in the large-cap space. Yet another cost active funds incur is impact cost. Especially in the case of small-cap stocks, where market capitalisation is low, the fund's own purchases push the price of the stock way past its current bid-offer price, thereby raising the cost of acquiring them.
Another subliminal cost that buyers don't notice is the cost of cash. When markets go into a tailspin, actively-managed funds move into cash in order to stem the decline in their NAV. This has a cost. When the markets revive, any delay in switching from cash to stocks causes the fund's performance to lag. Since passively managed funds are always fully invested, their cost of cash is low. The greater the cash position, the greater the impact of this cost on active funds.
The author says that as the investment horizon increases the chances of an actively-managed fund beating a passively-managed fund declines even further. The burden of expenses increases over time due to compounding, thereby, making the task of active fund managers much more difficult.
Difficult to pick tomorrow's winners
Investors would argue that they don't care if the majority of actively-managed funds underperform the index because they would invest in the outperformers. But therein lies the next big problem. The author cites many studies in the US which have found that the link between past performance and future returns is tenuous, if not non-existent. It is almost impossible to predict in advance who the outperformers will be over the next 10-15 years. The author drives home this point by citing the example of pension funds. Since they have vast resources at their disposal, pension funds conduct elaborate exercises to identify the best fund managers. They even employ the likes of Goldman Sachs and Frank Russell to identify these managers. Despite their efforts, undertaken at considerable expense, the returns earned by the managers who get selected have been quite abysmal. A large number of pension funds in the US have given up on active funds and moved their corpuses to passive funds.
Seeds of its own destruction
Another damning argument the author makes against active funds is that their success sows the seeds of their decline. If a fund does well, it gets lots of inflows and its assets soar. Once this happens, fund managers have two options: either they can remain a concentrated fund or they can diversify.
With a huge corpus, remaining a concentrated fund is not easy. If they invest in large-cap stocks, outperforming the benchmark becomes difficult because the large cap market is efficient and there are not many information-based advantages to be exploited. The other option is to move into smaller-cap stocks. In this market, which is not as well researched, information-based advantages can indeed be exploited. But these markets have low liquidity, and the bid-offer spread is high. Investing in this market raises the fund's trading costs. It also raises their impact cost (explained earlier).
The other option is to turn into a highly diversified fund. But then the fund risks becoming a closet index fund. In other words, it is actually an index fund but charges the fee of an actively-managed fund. Thus, as fund size swells, no matter what strategy the fund manager adopts, outperforming the index becomes difficult. The implication for investors is that by the time they hear of a fund manager's success, it may be too late to benefit from his skills. If they invest in a fund that has shown great returns lately, in all likelihood they will only see its performance plummet in future.
One drastic option before fund managers is to stop further investments in their funds. But most fund managers are loath to do so because a fund house's earnings are a percentage of total assets. All this has come to light in the US because a lot of academic studies on these issues have been done there. It is time Indian academicians too begin to focus on these questions vis-à-vis the Indian market: is the Indian market truly as inefficient as it is made out to be, offering opportunities for active funds to outperform? What percentage of active funds outperform their indexes over larger time horizons of 10-20 years? And is investing on today's outperformers a guarantee of continued outperformance in future as well? Until such studies are conducted, our decisions will be based not on data but on the advertising spiel of the fund management industry, which, for obvious reasons, has a vested interest in asserting that active management is superior to passive management.
This article was originally published on September 16, 2010.
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