X
<

Think Actively Managed Funds Always Outperform? Think Again

PART:
1
Think Actively Managed Funds Always Outperform? Think Again PART 1 OF 1

Think Actively Managed Funds Always Outperform? Think Again

Partner Voice: What's this? Partner Voice allows financial brands to connect directly with the Market Realist audience to provide educational information about investment choices. Each report is produced by the financial brand and approved for publication if our research team deems it educational and suitable for the Market Realist audience. Market Realist may receive payment or other compensation from these financial brands. The opinions that financial brands express in these reports are their own.


When I tell people about the seven-day race I ran in the Sahara last year, they ask questions. The most common one is, “Why?”1 A close second is, “How did you get all the water you needed?”

Now, you’ve probably heard that you should drink eight glasses of water a day. It’s one of those bits of conventional wisdom that a lot of people just absorb along the way. But it turns out not to have a lot of data behind it.

There’s no formal recommendation for water intake. The eight-glass figure appears to come from a 1945 report recommending 2.5 liters a day. And even then, the report suggested much of that could come from food.2

Do the best active managers know more?

That’s how conventional wisdom often works. A widespread “fact” becomes so ingrained that it’s slow to change. Here’s another bit of conventional wisdom you might have heard: The less efficient that a market is, the more likely that an active manager will be able to outperform.

It makes sense at first glance. If there is less informational efficiency, the odds increase that a manager with an informational edge can consistently beat the market.

But just like our water example, we need to ask if there are data behind this idea.

What the data say

To test the conventional wisdom on active management, let’s examine active managers in U.S. small-cap equities and emerging markets equities. There’s a general belief in the industry these are easier segments of the market in which to outperform because there are more informational advantages available to active managers. So it seems reasonable to expect to find active funds that consistently outperform their peers over long periods.

The chart below tests that hypothesis. It shows the most recent five-year performance (from 2012 to 2016) of active funds that performed in the top quintile over the previous five-year period (from 2007 to 2011). Going by the conventional wisdom, we’d expect to see most of these funds remain on top.

Outperformance tends not to persist
Think Actively Managed Funds Always Outperform? Think Again

Source: Vanguard
Note: Percentages do not add up to 100% due to rounding.

Instead, we see the opposite. The most common result for the top performers from 2007 to 2011 was to fall into the bottom quintile over the next five years. A significant number of funds ended up merged or liquidated in the five years following top-quintile performance.

The conventional wisdom does not hold.

Conventional wisdom can’t win the zero-sum game

Let’s take a step back and remember that the stock market is a zero-sum game.3 Every time an investor makes a profitable trade, another investor must take the opposite side and incur an equal loss. And investors are subject to costs to participate in the market.

While inefficient market sectors could offer informational advantages with attendant opportunities for outperformance, their participation costs (such as wider bid-ask spreads, market impact, and expense ratios) are significantly higher than in larger, more liquid areas of the market. Remember, you only keep after-cost returns.

With improvements in technology and rising competition, it is becoming increasingly difficult for active managers to consistently outperform relevant market indexes net of all costs. They’re no longer competing against “mom and pop.” They’re competing against the professionals in the neighboring skyscraper, and the ability to find an informational edge is shrinking along with their margins.

Outperformance requires talent, low costs, and patience

So does this leave active investing in the same boat as the myth about the eight glasses of water? Not really. But if the best way to get ahead in active investing is to know something other investors don’t, perhaps the first thing to reconsider is the conventional wisdom.

Our research shows that long-term, active outperformance is possible. But choosing recent high performers in inefficient markets isn’t the answer. Instead, we found that low-cost funds run by talented managers can achieve long-term outperformance for patient investors. Patience is key, because returns will be inconsistent even for successful managers.

One good way to learn patience is running a seven-day race in the desert.4 And while we’re rethinking, I can report another flaw in conventional wisdom. You need way more than eight glasses of water a day when you run through the Sahara.

I’d like to thank Tom Paradise, Kunio Iwata, and Tim Clavin for their invaluable contributions to this blog post.

1 I have three teenagers at home. This was a vacation.

2 Food and Nutrition Board, National Academy of Sciences, 1945. Recommended dietary allowances, revised 1945. Washington, D.C.: National Research Council. (Reprint and Circular Series, No. 122.)

3 William F. Sharpe, 1991. The arithmetic of active management. Financial Analysts Journal 47(1):7–9.

4 There are much easier ways.

All investing is subject to risk, including the possible loss of the money you invest. Prices of small-cap stocks often fluctuate more than those of large-company stocks. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

Keys to improving the odds of active management success.

Chris Tidmore

Chris Tidmore, CFA, is a senior investment strategist in Vanguard Investment Strategy Group. Before joining Vanguard in August 2015, Mr. Tidmore was the managing partner of Butcher’s Hill Capital, LLC, which managed the Geneva Arbitrage Fund. The Geneva Arbitrage Fund employed both merger arbitrage and event-driven investment strategies. Before the launch of the Geneva Arbitrage Fund, Mr. Tidmore worked as an arbitrage trader, analyst, and portfolio manager for a family-owned holding company. In addition, he was an options trader on the American Stock Exchange. Before his work in the securities industry, he was employed as an auditor, providing audit, accounting, and consulting services to various charitable and governmental organizations. Mr. Tidmore has developed and taught courses in financial accounting, financial statement analysis, asset valuation, equity derivatives, trading, portfolio management, alternative investments, and CFA® and CPA review courses for an extensive list of clients. He also has lectured on various accounting and finance topics to both the CFA Institute and the CFA Society of Philadelphia. Mr. Tidmore earned a B.S. in accounting at the University of Delaware. He is a CFA charterholder and is a past president of the CFA Society of Philadelphia.

CFA® is a registered trademark owned by CFA Institute.

View more posts by Chris Tidmore

For more information about Vanguard funds or Vanguard ETFs, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bonds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

All investing is subject to risk, including possible loss of principal. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.

X

Please select a profession that best describes you: