Session 35 (of 42): The Case for Passive Investing - Active Investors' Track Record

0:01 Hi, welcome back. Now that we've talked about all of the different investment philosophies from stock picking to market timing, from value to growth, from information trading to arbitrage, we're going to come back full circle and ask the question, should we be even trying to beat the market? Should we be buying actively trying to pick stocks and time the market? And in this session, the push back begins on active investing. So to see how active investing has come under assault in the last three decades, maybe four decades, take a look at this graph. This graph here's what you see. You see active investing in all of its different forms, equity, mutual funds, hedge funds, etc.

0:44 And it looks at index funds and ETFs, which are passive investing vehicles. It cost you almost nothing to invest in an index fund. You put your money in there. and it looks at the percentage of overall money in the market that comes from active and passive sources. If you look at ETFs and index funds, they used to be almost none of the market in the in the I know index funds were create in the 1970s, but they were a tiny segment of the market. And over the last 40 years, here's what you've seen. You've seen active investing's market share go from close to 100% 94 95% in the 1980s down to about 35% in 2024.

1:29 That's a pretty substantial change you've seen over time in the growth of passive investing. And this has given of course active investing active investors a whole lot to worry about. and there and it raises questions about what it is that's causing the shift. I think the reason is very simple. The case for passive investing, investing in index funments and ETFs is made by active investors and how they performed relative to the market. As you will see in the rest of the session, the history of active investing reflects a reality which is active investing collectively has failed to deliver on its pro promise and has actually underperformed the market. We'll talk about both the data and the intuition as to why that might be. But there are two subsegments or two questions you need to address in active investing. Before we turn to mutual fund managers and hedge funds and all the rest of the active investing players, you can ask about individual investors.

2:29 You can say, well, maybe they fail for other reasons, but I am an individual investor. What is the history of individual investors with the market? We'll start with that, but then we'll turn to professional money managers and see if their record is different, better or worse than individual investors. Let's start with what individual investors do relative to the market. The overall evidence looking at individual individual investors is the average individual investor does not beat the market. And in fact, the more they trade, the lower their returns tend to be. The more active they are, the lower their returns tend to be. and pooling individual investors into investment clubs or today in social media doesn't yield better returns. So the overall evidence on individual investors is they don't beat the market but there is a glimmer of hope. There's a subset of individual investors who seem to beat the market and what they share are the common first. They stay with what they know, stay local, stay in businesses they know and perhaps that's where the competitive advantage becomes and the winners win big. The top 10% of tra traders outperform the bottom 10% by a huge amount. So there's some individual investors who do beat the market. The answer is yes. Do they do it because they're lucky or because they're skillful, it's tough to know. This is a game where separating luck luck from skill is is difficult to do. But the fact that they exist is good news for individual investors who keep trying.

4:00 You see, what about professional money managers? At least in theory, they should be better informed, have smarter, have more data, bigger, better tools than individual investors do, right? And at least in theory, they should earn higher returns than individual investors and have better odds of beating the market. The data doesn't back that up. In fact, the earliest study of money managers was in the 1960s when Michael Jensen, who was then teaching at the University of Chicago, took 120 plus mutual funds.

4:33 That's how many mutual funds there were in the US. And he asked a very simple question. How much does the average mutual fund manager beat the market by? The reason he framed that question that way was the conventional wisdom in the 60s was professional money managers no more have better tools. And let's face it, in the 60s they have advantages over the rest of us. Therefore, they must do better than the rest of us. And what he uncovered remains one of the most sustained findings in finance. He found that the more than 60% of mutual fund managers closer to 70% actually underperformed the market and the average mutual fund manager underperformed the market by about 1 to one and a 12%.

5:15 That difference he got by comparing what they earned to what they should have earned given the risk and given what the market did. He called Jensen's alpha. He called it alpha but it became called Jensen's alpha. And to this day in active investing that word hangs in there. alpha captures how much a mutual fund manager or a money manager makes over and above what they need to make given the risk they want to take on. So Jensen's finding was that mutual funds don't beat the market. They underperformed by about 1 to one and a half%.

5:44 Now a little later in the process, people looked at bond funds and there the finding remained the same. The active bond fund underperformed an index of bonds by about 20 to 30 basis points. both stock and bond funds when actively managed by professional managers underperformed indices. Now of course when this evidence was first presented to active money managers their response was it must be something in the model that they used that the you know the Michael Jensen for instance used the capital asset pricing model to come up with expected returns. So the push back was maybe the model is wrong. Maybe we do beat the market and you're you're coming up with your results because your risk and return models are wrong. So over the last 40 years, people have tried variance or no model at all.

6:32 You're saying what does that mean? You can compare the returns that active money managers make to just the S&P 500, right? And look at what percentage beat the market. If you think about it, at least 50% should beat the market, right? I mean in any given period and if you look across the last 25 years in this century look at that that statistic this is a so that you can't blame risk and return models this is the percentage of equity fund managers who beat the S&P 500 there have been only what a few years a handful of years where that number is higher than 50%. In most years, the index beats the average equity mutual fund manager. And if you decide to bring in other ways of controlling for risk within the CAPM, of course, we talked about the sharp ratio, the trainer measure, the Jensen's alpha, they all indicated underperformance.

7:28 When people try to arbitrage pricing models, the conclusion remained the same. In fact, as you look across 40 years of trial and error with different risk and return models, you might get variance on how much you get as an ex as in your finding. But across these models, the conclusion seems to be the average active money manager doesn't beat the market. Now, we also in the context of risk and return talked about proxy models where people brought in market cap and price to book. Now before these proxy models entered the game there was a simple way in which a mutual fund manager could beat the expected return. You invested overinvested in small cap stocks or low price to book stocks. The last century you look like you beat the market after controlling for risk not because you actually beat the market but because of a failure in the model. And it was in response to that underperformance by risk and return models that you start to get proxy models where you brought in factors to come up with expected returns. Now what happens when you use these models to look at active money managers? It turns out that active money managers who artificially beat the model no longer do that you can't just do this by buying small cap stocks. In fact, in 1997, one of the most widely cited mutual fund studies, Carheart used a four factor model, beta market cap, price to book, and price momentum. And he concluded the average mutual fund manager underperformed the market by about 1.8% a year. That's why I call this one of the most persistent findings in finance that the average active money manager underperforms an index by about 1 and a half to 2%.

9:07 Now along the way, one of the things people noticed about these studies that was actually biased in favor of active money managers was failing to account for the fact that if you're a bad money manager, over time you tend to cease to exist. There's a survivor bias. Now, Carart in his 1990s study actually chronicled how much of a survivor bias there was by looking at how many funds failed or ceased to exist. And he found that over his period 3.6% 6% of funds failed to exist. You're saying each year 3.6% of funds failed and that many of these funds were the worst performing funds. So if you didn't allow for the survivor bias, if you just looked at mutual funds in existence today and work backwards, you're likely to overstate the performance of mutual funds by about.17%.

9:56 In fact, the greater the survivor problem, the more bias this creates. We talked about this in the context of hedge funds where an even larger percentage fail on an annual basis. So the bottom line is you can't blame overall mutual fund performance on models or periods across time. Active money managers have had trouble matching up to the market. Now of course active money managers come in lots of different forms, right? Variety of styles. You can be a value money manager, f a growth money manager, large cap, small cap stocks. You can also be a small fund and a big fund, domestic funds, foreign funds. So the question, if you're an active money manager, is there a glimmer of hope? Is there a subset of money managers who do beat the market? And I'm going to give away the bad news before I even show you the data. No, there is no good news. When you look at small cap, you know, mutual fund manager invest in small cap and large cap stocks and you compare them to their relative indices.

10:55 So you take the small cap funds and you compare them to small cap index. Large cap funds and you compare them to large cap index. Across time at least you look at the percentage of money managers who beat the market. Slightly better odds with small cap funds and large cap funds but only you know in individual years. Across time both small cap and large cap cap funds have struggled to beat the market. There have been individual years where both groups have beaten the market. But across time, neither small cap nor large cap funds have had more than 50% beat the market.

11:32 So this is a comparison to the index. It's a very clean comparison. If I want to invest in small cap stocks, I can either buy the index fund or I can buy an active small cap fund manager. And historically, I'd have been better off buying the index fund. You're saying, what about value versus growth, midcap, large cap? This is this is a graph that I pulled out of SPA which is a S&P site which does an incredible service.

11:58 They compare active money managers to the market and they control for styles by comparing to an index based on the stats. If you're a value manager, they compare you to value index, a growth manager to growth index and they chronicle a very simple statistic. What percentage of managers are outperformed by the market? See those pie charts? See the orange part of the pie charts? That's the percentage of money managers who are outperformed by the index. That's astonishing number, right? 90% 93% large cap growth funds 100% of the active money managers are outperformed by the index. No matter how you slice and dice active money managers, there isn't a segment or a style that seems to beat the market.

12:49 Now over the last few years, Piva has expanded its search across the globe and they chronicle in each part of the globe what percentage of active money managers are beaten by the market. I'll tell you the story why this makes you know this the answer or the the question to which this analysis responds. Is there a bigger payoff to active investing in a market where information is tougher to get where a market that's you know an emerging market without much of history in investing? You could tell a story that if you're investing in a country where there's not much history of investing that a professional money manager might do better. There's very weak evidence of that happening. There only two parts of the world where active money managers beat the index more than 50% of the time. One in South Africa 42 49 47. So barely you know barely above 50%. And in the Middle East where at least for the long term so the three numbers are one year, 5 year and 10 year. If you go to the long term in the Middle East, you you lose. But in the short term, money manage active money managers beat the index in every other part of the world.

14:02 Oh, and Mexico and for whatever reason and made again it's very similar to the Middle East. In the short term, money managers win. In the long term, not so much. In every part of the world, if you go to that 10-year, the long-term, in every part of the world, the indices beat active money managers. And it's not just stocks. If you do this with bonds and you compare active bond funds to bond indices, again, every slice of active bond investing, short-term, long-term, governments, corporates, every kind of fund, you find the index beating an active money manager. So, here's the bottom line. And it's not good news if you're active money manager there. No matter how you slice the data, historically by style, by geography, active money managers have struggled to match up to the index. And across all time periods, the underperformance is not just there, but it's rampant. It's big. You can't ignore it. And even in emerging and smaller markets, at least in theory, active money managers should have an advantage, it's not there. Now, if you're puzzled as to why this might be happening, how come all this brain power and data and tools don't pay off in higher returns, we will talk about what it is that's beeviling active investing and why it's becoming more difficult over time to actually be an active investor in the next session or two. I hope you found the session useful and I thank you very much for listening.