Why it pays to go passive

841-Grass-634 — Even the best struggle to beat doing nothing

Every year, index provider S&P releases a "scorecard", which looks at how active funds have performed compared to passive ("tracker" or "index") funds. It usually makes gloomy reading for active managers. But this year was worse than usual.

For the first time ever, S&P looked at the 15-year track records of active funds, to see how they did against their benchmarks over an entire economic cycle. A staggering 82% of all US funds everything from large-cap to small-cap funds failed to beat the index. In other words, more than eight out of ten times, you'd have been better off paying lower fees to buy a simple index fund, rather than paying up for active management.

There is some consolation for active managers. Recent academic research, building on work in the late 1990s, suggests that they're failing not because they are stupid, incompetent, or even lazy. It's not even just down to the higher fees they charge. It's because it's even harder to beat the market than anyone had thought. Why? It boils down to the statistical phenomenon of "positive skewness". This describes the fact that the majority of the returns made by a stockmarket index are generated by a small proportion of the stocks in that index ie, a few stocks beat the wider index, while the majority underperform.

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This point was first made in 1998 by academics David Ikenberry, Richard Shockley and Kent Womack. A 2015 paper by JB Heaton, NG Polson and JH Witte drew attention back to the subject, and a 2017 paper by Hendrik Bessembinder of Arizona State University expanded on it, finding that 58% of "stocks do not outperform Treasury bills" (US government IOUs, viewed as the "safest" investments on the planet).

In fact, going back to 1926, the entire excess return over bills by US stocks "is attributable to the best-performing 4% of listed stocks". Because the majority of stocks underperform the market, this "virtually ensures everyone outside of an indexer owns mostly deadbeat stocks", notes Bloomberg's Oliver Renick. Hence the consistent failure of most active managers to beat the market.

What does this imply for investors? Firstly, it's another good reason to favour passive over active funds for exposure to a given index. Secondly, if you do invest in an active fund, you have to understand the strategy that the manager is using, and ask why it will outperform when so many others fail is it a tried, tested and evidence-backed method (such as value investing, for example)?

Finally, it flags up the importance of diversification yet again. If you are a stockpicker yourself, monitor your performance versus the benchmark, and consider owning an index fund to spread your bets efficiently.