When & How Active Managers Outperform

The debate over active or passive fund management is long in the tooth.  Proprietors of managed funds and advisors who sell them will always look for cracks in the data or a good narrative to keep selling their wares. And the financial media loves the debate, they know they will get clicks and readers by finding new ways to tell the story.

The most recent piece was from the Wall Street Journal a few weeks ago titled “Human Stock Pickers Gain Against Indexes.” The punchline is that in the story the WSJ reports that “active” funds have beaten index funds by…0.05% year to date. That’s an average number, and the article goes on to say that “nearly half” (that’s less than half, to be clear) of active managers beat their benchmarks. Nearly half! So exciting.

There’s regular arguments about when active managers are going to outperform.  Managers like to believe that active outperforms in bear markets, or when there is low correlation among stocks. (The whole idea of a “stock picker’s market” has been flatly debunked.) They pile on passive strategies when markets have been up strongly, saying it’s “easy” to be passive in a bull market.  I’m not sure they are right about that, but it still doesn’t mean that active stockpicking is a solution to run to in bear markets. (While the % of active managers that beat their benchmarks was slightly better in 2008, it was still under 50% according to Standard & Poor’s SPIVA studies).

In fact, I can show you a portfolio that “outperforms” just like an actively managed portfolio does, and then I’ll tell you why it does.  Here’s the annual outperformance/underperformance of my mock “active” portfolio compared to the Vanguard S&P 500 Index Fund (VFINX).

Jan – Dec 1997 -7.55%
Jan – Dec 1998 -7.20%
Jan – Dec 1999 -0.63%
Jan – Dec 2000 0.96%
Jan – Dec 2001 1.99%
Jan – Dec 2002 3.17%
Jan – Dec 2003 0.36%
Jan – Dec 2004 0.97%
Jan – Dec 2005 0.86%
Jan – Dec 2006 -0.37%
Jan – Dec 2007 0.05%
Jan – Dec 2008 2.80%
Jan – Dec 2009 0.51%
Jan – Dec 2010 -0.49%
Jan – Dec 2011 -2.25%
Jan – Dec 2012 -1.23%
Jan – Dec 2013 -4.60%
Jan – Dec 2014 -3.73%
Jan – Apr 2015 0.62%

Take a quick look and you’ll see that:

  • The “active portfolio” underperforms in big, strong bull markets in US stocks, as in ’97-’99 and ’12-’14.
  • The “active portfolio” holds up well in bear markets, like ’00-’02 and 2008.
  • And, just like the WSJ article referenced above, my “active” fund is beating the S&P 500 year-to-date in 2015.

So what’s the secret? I just did the same thing that most actively managed funds do – drifted away from large cap US stocks and kept a cash cushion. My “active” portfolio was:

  • 70% Vanguard 500 Index (VFINX)
  • 10% Vanguard Total International Stock Index (VGTSX)
  • 10% Vanguard Small Cap Index (NAESX)
  • 10% Cash

And just like the pendulum swing of when actively managed funds “beat their index,” my makeshift portfolio wins when large cap US stocks lose. The divergence between large cap US stocks, small caps and international explains the majority of the performance swings of actively managed funds. Below is a quick overlay of the data above with annual calculations from the S&P SPIVA scorecard on how often actively managed funds beats their benchmarks (this comparison is just for the large cap US fund managers).


There’s not a ton of visual correlation here, but what I see is that the very few times over 50% of managers beat their benchmarks, my mock up portfolio was ahead of the Vanguard S&P 500 fund.  When my mock portfolio did terribly, so did actively managed funds, on average.

There’s no secret time in the market when active managers do well. William Sharpe’s math remains:

If “active” and “passive” management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

There simply can’t be a time when the majority of active managers outperform, this isn’t Lake Wobegon and we aren’t all above average.  And much of the “outperformance” is really just asset allocation and managers drifting away from their target benchmarks into other asset classes. Stock picking is really, really difficult.  Picking the manager that might be able to be right about stock picking is probably even harder. Can we put this “stock picker’s market” and “return of the stock pickers” nonsense to bed now?

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