Twice a year, Standard and Poor’s provides an analysis of why index funds are better than actively managed mutual funds. Their report is known as SPIVA, S&P Index Versus Active. It is compelling evidence that investors would be better off using index funds. We’re going to look at the most recent data, discuss the perils of fund benchmarks, and then explain our approach of using Factor-based strategies.
Most Funds Lag Their Benchmark
Looking at 2021, 79.6% of US stock funds did worse than the overall market, as measured by the S&P 1500 Composite Index. It was a spectacularly bad year for active managers, even worse than most years. I focus on the long-term results, which are fairly consistent from year to year. For the 10 years ending 12/31/2021, 86% of US stock funds under-performed the market. Some of the funds which did out-perform did so by taking on much more risk. When we consider risk-adjusted returns, 93% of funds lagged.
The data is compelling and persistent. 80% or more of actively managed funds cannot keep up with their index over 10 or 20 years. And since that is the time frame that matters for long-term investors, the odds are in your favor if you use index strategies rather than active funds. It is extremely difficult for active managers to beat the index. There are many thoughts why this is the case:
- Higher expenses. The cost of running a fund seems to wipe out any value they create through research and active management. Overall, market participants add up to the entire return of the stock market. That is the benchmark. But instead of being average (or actually Median) at 50%, the additional costs mean that 80% of funds trail the benchmark
- Chasing performance. Active managers pay too much for hot stocks and ignore cheap stocks which are out of favor. Or they miss the handful of top performing stocks which are often the biggest drivers of market returns. Stocks, categories, and sectors go in and out of favor.
- No information advantage. Today, analysts are smarter than ever and information is disseminated instantly online. The markets may have become so efficient that there are no “secret” stocks for active managers to uncover.
- The 10-20% of managers who do outperform may have done so through luck, as they are typically unable to sustain out-performance from one period to another. Do we have data for that? Yes. It’s the S&P Persistence Scorecard.
There are a lot of benchmarks and unfortunately, this can be confusing for investors. Sometimes, we might be comparing a fund to the wrong benchmark and not be making the most accurate comparison. Consider, for example, the Fidelity Contrafund. At $126 Billion in assets, it is one of the most successful active funds in history. And over the last 10 years, it has slightly beat the S&P 500 Index: FCNTX is up 282% through April 22, 2022, compared to 279% for the Vanguard 500 (VOO).
Unfortunately, that’s not the most accurate benchmark, because the Contrafund is a Growth Fund. As a better benchmark, you could have been invested in the Vanguard 500 Growth Index (VOOG). And VOOG was up 333% over the past 10 years. In this case, the active fund actually trailed the correct benchmark by 50% over 10 years. With Growth strategies dominating over the past 10 years, a lot of Growth funds look good compared to the S&P 500. But when we consider a Growth benchmark, you probably would have been better off in the index fund. (And for taxable accounts, the after-tax return of active funds are very often much lower than an ETF.)
Here’s another poor benchmark situation. This week, I was comparing two US Low Volatility ETFs with very similar strategies: the SPDR Large Cap Low Volatility (LGLV) and the Invesco S&P 500 Low Volatility (SPLV). Looking at a Morningstar report of 5-year performance, it showed that LGLV was in the 60th percentile while SPLV was better, at the 40th percentile. Unfortunately, the report was using two different benchmarks: large blend for LGLV and large value for SPLV. Their actual 5-year annualized returns were 14.01% for LGLV and 11.36% for SPLV. With different benchmarks, LGLV looked worse (60th percentile), even though it had actually out-performed SPLV by 2.65% a year! Which benchmark you use matters.
Using Factors To Look Forward
Although SPIVA shows why index funds are better, the harder part is deciding which index fund you want to invest in. You could just choose a World Index stock fund, like the Vanguard Total World Stock ETF (VT). And I am confident you would do better than most active managers over the next 10 or 20 years.
But, we don’t invest in an “all-in-one” fund.
Rather, my role as a portfolio manager is to determine the asset allocation for each model and level of risk. We decide which categories we want to own (large growth, small value, emerging markets, etc.) and what percentage to invest in each category. And rather than looking backwards at performance, we use today’s valuations to evaluate future performance. Once we have an asset allocation model, I can select an index fund to use to fulfill each category. It starts with the blueprint, not the funds themselves.
Rather than using generic index funds like a Total World Index fund, we buy 5-8 Index funds that invest using a “factor” strategy. This is a quantitative way of sorting stocks, using a characteristic such as Value, Size, Quality, or Low Volatility. They represent an Index or Benchmark, but have an additional screen to create a portfolio with specific qualities. There is evidence that Factors can outperform a benchmark over time, but clearly, they do not do so every year.
Today, we are concerned about some stocks’ high valuations. We have tilted our portfolios away from the large cap growth and technology names which have had such terrific performance that their values are so expensive today. Some of these stocks, such as Facebook (now called “Meta”) are down 45% year to date. That’s what can happen when a stock becomes too expensive and the market winds change direction.
Instead, we are looking ahead in anticipation of a reversion to the mean in categories such as Value, Small Cap Value, International and Emerging Markets. That’s no prediction that any of these will be up this year, it’s a long-term proposition. When I look at the S&P 500 Index today and see how expensive some of the names have become, I find it hard to stomach. And so, we are looking for ways to take advantage of passive, low cost, tax-efficiency of ETFs, but in a smarter manner than just throwing it all in a generic, market cap weighted index fund.
Once we understand why index funds are better, we are still left with two questions. Which benchmark to use and how do we want to invest? We are fortunate today to have easy access to many low cost index funds. Factor-based funds can help us establish potentially positive characteristics to our portfolios even compared to regular index funds.