Indexed and passive investing have gotten a bad rap from active managers out to protect their turf and the high fees they earn from buying and selling securities. Passive managers buy a portfolio that matches a market index or that covers an entire asset class. Plenty of academic research suggests that they will do better than the average active investor who tries to beat the market by either selecting the “right” investments or by timing when to buy and sell.
The passive investment managers now have a 10-year real world test to back up their theory: the Standard & Poor’s Indices Versus Active scorecard, known as “SPIVA.” For a decade S&P has tracked the performance of its stock and bond market indexes compared to the performance of active mutual fund managers. The results have given strong backing to passive management proponents.
Active managers have long argued that they do better during bear markets, because they have flexibility. Unlike passive managers, who must continue to be fully invested, active managers can buy and sell and play defense. But in the two bear markets covered by the SPIVA scorecard, the majority of active fund managers failed to beat their index benchmarks. For instance, in the 2008 bear market almost 84 percent of small-cap stock funds failed to beat their index, while 53 percent of large cap managers were bested by their relevant index.
Municipal bond funds turned in the worst performance: Just 9 percent of national muni bond funds outperformed their indexes, while not one New York or California muni fund did so. This points out one of the arguments for passive investing: it is cheaper than active investing because trading and management fees are low. Active muni bond funds may not have done so bad vs. their indexes on a gross return basis, but since returns on munis are modest, after subtracting fees they ended up trailing the indexes.
The SPIVA scorecard demolishes another myth: that managers investing in stocks of small companies are more likely to outperform their relevant indexes. This myth is based on the claim that while large company stocks are priced efficiently because they are so widely followed, small company stocks are less well known and therefore provide an opportunity for savvy managers to select the best stocks. Over the decade covered by the scorecard the majority of small stock funds were beaten by their indexes.
During particular years or short periods, active managers sometimes do beat their indexes. However, on average, given a five year period, it appears that the majority of active managers fail to beat their indexes, SPIVA shows. For instance, from June 2006 through June 2011, 63 percent of large stock funds were beaten by the S&P 500 Stocks Index. During the previous five years, almost 70 percent of the big company managers lagged behind the index. Finally, the scorecard may make active managers look even better than they really are. Each year during the study up to 20 percent of active funds went out of business. If they were included in the study, active management would have looked worse.
