Most Managers Fail to Beat Passive Benchmarks.

Active investment managers – that try to outperform a passive/index benchmark, such as the S&P 500 – have generally not been successful over the last several decades. Despite numerous studies over the years, there is little or no evidence that active managers outperform market index returns over sustained periods of time. There is anecdotal evidence that some active managers have performed very well, but this quite rare, and is likely do to luck.

The index benchmarks have proven to be a very difficult hurdle; in fact, over the past 10 years, 90% of Canadian equity managers failed to beat the S&P/TSX Composite, Canada’s primary benchmark index. [1] Among managers of US equity, a whopping 97% of managers failed to beat the S&P 500 Total Return over 10 years, and 95% of international equity managers failed to beat their passive benchmark. Even for the few that do manage to outperform, there is little or no evidence of skill. It is likely just plain old luck.[2] To use an analogy, the probability of getting at least 8 heads when tossing a coin 10 times is about 5%. Would we say that this minority of people who succeed at this task are skilled at tossing coins, and the other 95% are unskilled? Of course not. Incidentally, the 5% figure is not far out of line with the fraction of managers whose performance really does stand out over any given period.

Why do most managers fail to beat their passive benchmarks? Its is the logical outcome of increasing market efficiencies over time. Today, there are far more investment experts (and computers) sifting through publicly available information than there were in the 1960s and 1970s, when the technology was still in its infancy, and managing money wasn’t considered a serious career. So if beating the benchmark is just luck, shouldn’t about half of managers succeed? That may be true before you consider fees.  However, the typical fee on a balanced mutual fund in Canada is about 2%, and that is enough to ensure that the success rate is very low indeed.

Index investment management – any strategy that tracks the performance of passive benchmarks – has proven to be an extremely efficient and effective long-term strategy for both retail and institutional investors alike. Hence, we have witnessed an impressive shift, globally, from active management to passive, as investors increasingly catch on to indexing’s compelling advantages. This movement has been growing for many decades, and recently has become popularized with the use of exchange-traded funds (ETFs), which allow retail investors to gain index exposure directly, at very low cost.

A Word on Survivorship Bias

Survivorship bias is the tendency for people to focus on success stories among a history of successes and failures. For example, when metal helmets were introduced during the 1st world, a higher rate of head injuries were reported among combat soldiers. This alarmed the top brass, who were considering eliminating them, until it was pointed out that the reason there more injuries was because there were fewer deaths. Only the survivors were initially considered.

Past investment performance data is often skewed by survivorship bias. There is clear and persistent tendency for underperforming funds to drop out of performance surveys that rank the funds’ performance. Since survey participation in always voluntary, managers that do not perform well tend to withdraw their participation to avoid scrutiny. Also, start-up funds often will not report performance to fund surveys until they have established a favourable track record. Of course, if they are not successful, they are unlikely to report. In both examples, the average performance of surveyed fund managers is overstated and, in fact, it makes it appear as though active managers are better than they are versus the passive index benchmarks.  The index benchmark return is not affected because it is a reflection of all investors’ performance – not just the survivors. Scientific studies, like the one referenced here, show that once you adjust for survivorship bias, professional active managers have not performed nearly as well as it first appears.

[1] S&P Dow Jones Indices. SPIVA Canada Scorecard Year-End 2018
[2] Luck versus Skill in the Cross-Section of Mutual Fund Returns by Eugene F. Fama and Kenneth R. French, Journal of Finance, September 2010.

“Perhaps there really are managers who can outperform the market consistently – logic would suggest that they exist. But they are remarkably well-hidden”.
– Paul Samuelson, Ph.D., Nobel Laureate, Economics (in Journal of Portfolio Management, 1974)