This post is to be read in conjunction with General Advice Warning detailed at the end of this post.
Introduction:
For decades the asset management industry has built itself on the reputation and central tenant that in order to achieve superior long-term returns an investor needs to ‘beat the market’. That to merely accept ‘beta’, the average market return, is somehow a suboptimal outcome; one that short-changes investors from the spoils on offer through active management.
Is this the case?
Do active managers beat passive index-based funds?
Well the answer is: It depends… It depends on how you approach the situation.
What is narrowly true is that yes, there are some funds out there who beat the indices and have arguably an enduring ability to do this.
The problem, like most things that are narrowly true, is that as soon as you interact this narrow truth with the messiness of the real world, its ability to remain an enduring, dependable truth is challenged.
What do the numbers say:
The key issue and challenge for everyday investors and financial planners alike can be summarised as:
- There are 2,134 companies listed in Australia1 (ASX 2020)
- As of 2019, there were 32,459 companies listed globally2 (World Bank 2019)
- Per the Morningstar Fund Screener3 there are 9,502 Australian based managed funds available to investors.
- Per S&P Global Research division SPIVA, the portion of funds that underperformed their benchmark on an absolute return basis was as follows:
Percentage of fund that underperformed their benchmark (time period)
| Country of Fund Domicile4 | 1-year | 5-year | 10-year | 15-year |
| Australia | 61% | 80% | 84% | 85% |
| U.S.A. | 70% | 83% | 89% | 89% |
| Europe | 71% | 77% | 87% | N/A |
Underperformance is not the only challenge. Staying in business is also a key issue. The survivorship rate of managed/mutual funds in the aggregate poses practical challenges for long-term investors. Per SPIVA research, the regions below experienced the following survivorship rates:
Percentage of fund that were still in business (time period)
| Survivorship rate of domestic funds4 | 1-year | 5-years | 10-years | 15-years |
| Australia | 98% | 78% | 58% | 56% |
| U.S.A | 95% | 77% | 60% | 44% |
| Europe | 94% | 75% | 51% | N/A |
For a long-term investor and/or their financial planner if ‘beating the market’ is the objective they are faced with this reality:
- In order to beat the aggregate of the market, one presumably needs to be the owner or beneficiary of stocks that perform better than the market, net of any costs associated to owning them.
- Therefore, as a direct local investor, one needs to successfully select and/or de-select a collection of stocks from the 2,134 that will outperform/underperform their relevant benchmark.
- As an investor in Australian managed funds, an investor or their adviser needs to successfully pick a fund from the thousands and thousands available who in turn select from the 2,134 local shares and 32,459 global shares available, the ones that will perform better than the market.
- And if they want to execute a true long-term holding (10-years or more) they need to ensure they select from, ahead of time, from only the approximate 58% of current funds available that will even exist a decade from now.
Are there some fund managers who have the skill set necessary to, on an enduring basis continue to beat the market? Yes, Buffet did it for years. No one can definitively say ‘no one can beat the market’.
BUT what seems rather reasonable to hypothesise from the numbers here is:
- Picking the stocks that will beat the market on an enduring basis, anything more than 12 months seems tough. 60-70% of fund managers in aggregate in Australia, Europe and the U.S cannot do it.
- Beating the market for the long term, >10-years as a fund manager is very tough, with only ~10-15% of managers able to do it.
- Picking those managers i.e. getting the 1/10 odds right, in real time is likely very, very tough.
- Allocating your money for the long-term and avoiding moving it around so as to minimise realised capital gains tax is made especially challenging when it’s an almost toss of the coin if a fund will be in existence 10-years from now. To be fair, the funds that perform well in the 10-year period are likely to have increased odds of still being open. However, the challenge may be, will ‘past performance equal future returns’? That is, will they continue to beat the market and thus stay in existence?
Why not just pick the funds who are ‘proven’?
If it is possible to beat the market, then there must surely be funds that can do it. It does stand to reason that if there are funds that can consistently underperform, then surely there must be corollary funds that outperform?
The key challenge here is understanding if indeed a fund did outperform the market and shoot the lights out, was the outcome a result of skill or luck? With enough ‘monkeys throwing darts’ even chance alone suggests a portion of funds should be successful. The key question is ‘were they just lucky monkeys or was the sustained outperformance a product of skill?’
One way to try and distil the difference is to look at what is known as ‘persistence’. If a fund manager is indeed highly skilled, then their ability to outperform ought to be more enduring than the average. Equally, if they just got lucky then that transitory nature of their success ought to be shown as just that – a streak of luck.
Researchers at S&P (Luk, Gupta & Wang)5 looked at just this. They examined top performing funds (top 25%) in each of the following categories:
- Australian Equity General
- Australian Equity Mid/Small Cap
- International Equity General
- Australian Equity A-REIT
- Australian Bond funds
They wanted to know, how the top funds over the period Dec 2009 – Dec 2014 then faired in the following 5 years. Essentially posing the question: ‘the top 25% of funds for the 5-years to 2014, were they just lucky or did they have an enduring skill?’ Their findings were interesting.
The table below is an extract from their findings:
| Equity Category | Number of Funds in top 25% for 5-years to Dec-2014 | % of those funds still in top 25% in Dec-2019 |
| Australian Equity General | 81 | 0.00% |
| Australian Equity Small / Mid Cap | 26 | 0.00% |
| International Equity General | 58 | 1.70% |
| Australian Bonds | 14 | 7.10% |
| Australian Equity A-REIT | 18 | 0.00% |
| Total | 197 | 1% |
A total of 2 funds were able to maintain their enduring top performance and stay in the top 25% of funds.
Cutting them further leeway and analysing, how many of the top 25% of funds were able to at least stay in the top 50% overall (so, continuing to outperform the market overall), helped somewhat.
For the funds that closed off the 5 years to December 2014 as a top 25% fund, then saw the outcome of remaining a top 50% fund be as follows:
| Equity Category | % of top 25% of funds remaining in top 50% for next 5 years | % of top 25% of funds either in bottom 50% or liquidated / merged |
| Australian Equity General | 37.1% | 62.9% |
| Australian Equity Small / Mid Cap | 40.1% | 59.9% |
| International Equity General | 59.5% | 40.5% |
| Australian Bonds | 75% | 25% |
| Australian Equity A-REIT | 43.8% | 56.2% |
Researchers also looked at changing the focus and looking at those funds who beat their benchmark for just the single year 2015, and then examining how they fared for the next 5 years. Potentially looking for funds that were ‘just getting started’ shows the following.
| Equity Category | No of funds that beat their benchmark in 2015 | % of those funds still outperforming at end of 2019 |
| Australian Equity General | 221 | 1.4% |
| Australian Equity Small / Mid Cap | 83 | 1.2% |
| International Equity General | 68 | 1.5% |
| Australian Bonds | 13 | 0% |
| Australian Equity A-REIT | 12 | 0% |
| Total | 397 | 1.3% |
Summary:
Picking a superior fund that will endure in its success of outperforming, is in a practical sense, nigh on impossible. They may be out there, but the realistic odds of an investor or adviser doing so in a repeatable, dependable fashion is a stretch to say the least.
Does this mean no one should never invest in active funds? No. It just means that anyone who does ought to do so from an eyes wide open perspective – understand the numbers, base rate and the situation. There may be other secondary factors that come into consideration beyond just ‘how does this fund measure against its benchmark over the long-term’.
The more fundamental issue perhaps at play, is that of motive: Why would / does a person need / want to invest in active funds?
If the need or want to invest in active funds is because their plan even with all the other ‘levers pulled’ still won’t see them achieve their goals, that they are actually reliant on the hope the active fund outperforms. Well, they probably have a poor underlying strategy and/or objective which is not realistic, reasonable nor attainable. This is likely of greater priority to address instead of trying for a moon shot of a fund selection.
Bottom line: There are a very small number of funds that may outperform and sustain it but trying to pick them out of the proverbial haystack, well the numbers suggest that is very bloody hard thing to do.
References:
- ASX, ‘The Official List’, August 2020. https://www.asx.com.au/asx/research/listedCompanies.do
- World Bank, ‘Listed domestic companies, total’ August 2020. https://data.worldbank.org/indicator/CM.MKT.LDOM.NO?end=2019&start=1975&view=chart
- Morningstar, ‘Fund Screener’ August 2020. https://www.morningstar.com.au/Tools/NewFundScreener
- SPIVA, ‘SPIVA Statistics & Reports’, 31.12.19 https://www.spindices.com/spiva/#/reports
- S&P Global, ‘Persistence of Australian Active Funds’ December 2019. https://www.spglobal.com/spdji/en/spiva/article/australia-persistence-scorecard
General Advice Warning
This post, the research, ideas, theories and conclusions presented in it are for general advice and / or informational purposes only. Your personal circumstances, situation or objectives have not been taken into account when preparing it.
No person should make a decision regarding their investments, superannuation or insurances polices based on this information alone. You should before making any decision with respect to your investments, superannuation or insurance policies consult with a financial adviser to determine if the decision is an appropriate one for you, your objectives, personal situation and needs.
If you would like to speak with me further about your specific situation, please follow the link below: