In the asset management world, the semiannual release of S&P Dow Jones’s SPIVA report generally gets a reaction. It’s simultaneously greeted with cheers and jeers—”I told you so,” “yeah, but,” “you’re hired,” and “you’re fired.”
SPIVA’s detailed summary of the performance of active funds versus various S&P benchmarks also sets off a mad scramble by bloggers, journalists, and other investment writers and commentators to interpret the results. And 2015 has been no different. As cash flows continue to gravitate toward passive vehicles,¹ I thought I’d offer my two cents on the eternal active versus passive debate.
Of course, if you’ve read any of my previous blogs, you’ll know that my two cents isn’t always as simple as a pair of pennies. In other words, I’m not going to beat the drum (much . . .) on passive outperforming active over time. It’s not just a matter of whether a majority of active funds underperform a comparative benchmark in the short or long run. Instead, I’m going to approach the benefits of incorporating passive management within a defined benefit (DB) or defined contribution (DC) plan from a different angle—the ability to invest responsibly for a given goal.
What I mean by responsible investing is this: limiting poor behavior such as return-chasing and market-timing. To demonstrate, I asked my colleagues in Vanguard Investment Strategy Group,² to calculate the investors’ return (internal rate of return, or IRR) and the funds’ return (time-weighted return or TWR) for both actively and passively managed U.S. equity funds in the Morningstar database.
Before I jump into any interpretation of data, there are two important caveats:
- IRR has as much to do with the timing of investor cash flows as with the sequence of returns in the fund. Therefore, in any individual example, a low or high IRR relative to a fund’s TWR at face value should not be blindly interpreted as poor or great market-timing ability. But when viewed across like funds over common time periods, we can begin to gain more confidence in our interpretations.³
- Specific values are highly dependent on the time period selected. In other words, we shouldn’t assume that the IRR for growth funds will be higher than the returns for the funds themselves, despite the results of the last ten years. That said, we would expect that the broader the index, the better investors will track that index.
Now let’s look at our additional data on IRR and TWR, shown in the figure below.
There are a number of takeaways, but I’m going to focus on the three most important.
- The average return for passively managed funds is greater than the average return for actively managed funds in a majority of the style boxes.4 This finding parallels the SPIVA report.
- The difference between the IRR and TWR for investors in passively managed funds is, on average, much lower than for investors in actively managed funds.
- The combination of points 1 and 2 means that investors in active funds have faced a stiff headwind, whether their objectives were saving for retirement, funding a DB plan, or meeting spending requirements for a nonprofit organization.
Ultimately, what we can take from this is that when an investment’s return deviates from an index, or when narrowly defined indexes deviate from the broad market, investors will more consistently lag the returns of their funds and by greater margins.
Therefore, while the push is for unbundling, complexity, “diversification,” and outperformance through more and narrower options, what we see is underperformance not only by the investments but also and more importantly by the investors themselves! Oh, and for those who discount these results as “retail,” remember that the Morningstar database has many institutionally used funds and that a DC plan is composed of “retail” investors.
Of course, there’s nothing wrong with active funds; but for a fiduciary or an investor the expectation should be for active funds to have a wider range of returns because of their greater risk, by definition. This in turn makes it more difficult for people to stay the course. Unfortunately, experience and data tell us that humans, whether they’re plan participants making decisions for themselves or investment committee members acting on the behalf of others, are highly likely to be influenced by swings in absolute and relative performance. And these decisions tend to result in buying high and selling low—part of the reason why the results above look the way they do.
So what can we do? Well, if the objective is to ensure the greatest probability of success for those who depend on it, increasing one’s allocation to passive investment options is one way that may help.
¹ Year-to-date through August 31, 2015, investors moved $38.5 billion into passive equity funds versus $114.2 billion out of active equity funds, and they moved $41.3 billion into passive fixed income funds versus $8.4 billion into active fixed income funds, according to Morningstar.
² Many thanks to Yan Zilberling for pulling the data.
³ For a detailed discussion of this phenomenon as it relates to Vanguard ETFs® and funds, see Kinniry, Francis M., Jr., and Yan Zilbering, 2012. Evaluating dollar-weighted returns of ETFs versus traditional fund returns. Valley Forge, Pa., Vanguard. In addition, the implication of the timing of investor cash flows is discussed in Bennyhoff, Donald G., and Francis M. Kinniry Jr., 2013. Advisor’s Alpha, Valley Forge, Pa., Vanguard.
4 This is not the best methodology with which to evaluate passive versus active, but it suffices for this example. For a more robust analysis of how actively managed funds have fared, refer to Philips, Christopher B., Francis M. Kinniry Jr., Todd Schlanger, and Joshua M. Hirt, 2014. The case for index-fund investing. Valley Forge, Pa. Vanguard.
• All investing is subject to risk, including the possible loss of the money you invest.
• Diversification does not ensure a profit or protect against a loss.