Study: Only 24% of Active Mutual Fund Managers Outperform the Market Index

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Conclusions

  • Only 24% of professional investors beat the market over the past 10 years
  • Index funds outperform actively managed funds by 0.80% annually, but active managers have lower risk
  • Active managers outperform the index by 0.12% before fees, but charge more in fees than the value they create
  • Large funds significantly outperform small funds with much higher returns and lower risk
  • Smaller stocks are riskier than large stocks, but don’t necessarily deliver higher return
  • Growth stocks significantly outperformed value stocks over the past decade

 

Do professionals outperform the market?  The data still says no.

Mutual fund investors must make the decision to pay to have their money actively managed by a professional or to passively invest in the market index at a lower cost.  Past academic studies have indicated that professional investors are not worth the cost because the after-fee return is lower than that of the market index.  Theoretically, active managers as a group will have a hard time outperforming the market over the long-run because professional investors are a large portion of the market and once fees are netted out, they are likely to underperform a passive index.

Despite the academic theory, investors have continued to pay for active asset management, preferring to try to pick a winner rather than playing it safe.  As of December 31, 2012 there was over $7 trillion invested in over 23,000 actively managed mutual funds and ETFs, almost three times the $2.5 trillion invested in passive funds.  Could this many people really be wrong?

NerdWallet investigated by examining the actual outcomes over the past decade of investing with active versus passive management.  The study looked at more than 24,000 mutual funds and ETFs available to U.S. investors for the ten-year period ending on December 31, 2012.  Of these, only 7,943 were in existence for the full ten years.

The asset-weighted average return of the actively managed mutual funds over this period was 6.50% while the passively managed index products averaged 7.30%.  Similarly, for equity funds the average return was 7.19% for active managers and 7.65% for passive funds.  Index funds outperformed actively managed funds regardless of whether returns were measured by asset-weighted average, median, or a simple average.

All Asset Classes
Active Index Index Outperformance
Asset-weighted Average 6.50% 7.30% 0.80%
Median 5.06% 6.42% 1.36%
Average 5.21% 5.77% 0.56%

 

U.S. Equity Only
Active Index Index Outperformance
Asset-weighted Average 7.19% 7.65% 0.46%
Median 6.36% 6.55% 0.19%
Average 6.34% 6.79% 0.45%

In fact, only 1,863 of the 7,630 of the actively managed products, or 24%, outperformed the index average return of 7.30%.    Only 1,570 (21%) outperformed the index by a statistically significant amount.  More simply, the majority of people who paid a mutual fund manager to invest their assets over the past decade would have done better by simply investing in a passive index fund, typically at much lower cost.

While these numbers do not make active investment management look like a wise decision, the truth is probably even more dire.  This analysis looks only at funds that were still in existence at the end of 2012.  The actively managed funds that did poorly enough to shut down are no longer reporting and are therefore not included in this analysis.  This survivorship bias implies that index fund returns are even more superior to active fund returns than the numbers indicate.

 

Negative skill or high fees?

So are professional investors really underperforming the market or are they earning positive alpha (returns in excess of the market) but capturing all of the gains for themselves with high fees?

The data shows that the latter is the case.  Active managers earn 0.12% higher annual returns than index investors before fees, but because they charge an average fee of 1.07%, much higher than the average index fee of only 0.15%, active investors are left with 0.80% less than index investors despite their manager earnings superior returns.

All Asset Classes
Active Index Index – Active Interpretation
Average Returns 6.50% 7.30% 0.80% Index has higher take-home return
Average Fees 1.07% 0.15% -0.92% Index has lower fees
Average Returns before Fees 7.57% 7.45% -0.12% Active has higher pre-expense return
*All numbers are asset-weighted

 

U.S. Equity Only
Active Index Index – Active Interpretation
Average Returns 7.19% 7.65% 0.46% Index has higher take-home return
Average Fees 1.12% 0.12% -1.00% Index has lower fees
Average Returns before Fees 8.31% 7.77% -0.54% Active has higher pre-expense return
*All numbers are asset-weighted

 

The case for active management

High returns are one goal of investment management, but controlling risk is also extremely important.  Betting it all on black has the potential for 100% returns, but would not be most people’s idea of an attractive investment due to the high risk of losing everything.

To examine risk, NerdWallet looked at the volatility of returns over the past decade for all 7,000+ funds and found that active managers controlled risk more effectively than index managers.  The asset-weighted average volatility of returns to active management was 14.14% per year, while the same risk measure was 16.1% for passive managers.  So while active managers slightly lag passive managers in after-fee return, the active managers are able to earn nearly the same returns with less risk.

All Asset Classes
Active Index Index – Active Interpretation
Volatility of Returns 14.14% 16.10% 1.96% Active has lower risk
Returns 6.50% 7.30% 0.80% Index has higher after-fee returns
Risk-adjusted Return 0.46 0.45 -0.01 Risk-adjusted returns are similar
*All numbers are asset-weighted

 

U.S. Equity Only
Active Index Index – Active Interpretation
Volatility of Returns 17.69% 17.91% 0.22% Active has lower risk
Returns 7.19% 7.65% 0.46% Index has higher after-fee returns
Risk-adjusted Return 0.41 0.43 0.02 Risk-adjusted returns are similar
*All numbers are asset-weighted

So which is better?  The answer is subjective.  Each individual likes return and hates risk in different proportions.  A simple measure of risk-adjusted return is to divide return by risk (used in the above table), but a more risk-averse investor may weight volatility more heavily, favoring the lower-return, lower-risk active managers.  An investor more focused on returns may decide the additional volatility of index management is worth the slight increase in risk.  The choice is a personal one with no correct answer.

 

Large Funds Significantly Outperform Small Funds

How much does the size of the fund matter to returns and risk?  Is it hard for larger funds to be nimble and beat the market because of their size or does a large portfolio benefit the manager in the form of increased access to company management and exclusive investment opportunities like IPO’s?

On this issue the data is clear.  The larger the fund, the better the performance, both in terms of returns and risk.  As fund size increases, returns steadily increase while risk declines.  Expense ratios decrease with fund size, indicating that a meaningful portion of expense is fixed.  Higher expense ratios for small funds explain up to one-third of their under-performance.

Mutual Fund Performance by Fund Size
Assets Under Management Return Risk Risk-Adjusted Return Expense Ratio
Under $10 million 3.57% 21.13%  0.17 1.86%
$10 to $100 million 4.31% 17.59%  0.25 1.40%
$100 million to $1 billion 5.31% 15.48%  0.34 1.29%
$1 to $10 billion 5.71% 14.67%  0.39 1.10%
Over $10 billion 6.99% 14.08%  0.50 0.92%

While lower fees and increased opportunities could explain the outperformance of larger funds, causation could also flow the other direction.  Successful investors gain assets under management through both higher returns on the money they manage and additional money invested due to their positive track record.  High assets under management could be a result rather than a cause of superior performance.

 

Are smaller stocks riskier?  Do value or growth stocks have higher returns?

Small stocks are traditionally considered to be higher risk and thus higher reward than larger stocks.  The data from the past decade confirms that risk decreases as company size grows, but lower returns do not necessarily follow.  The following table shows that mid-sized companies delivered the highest rewards, outperforming both small and large capitalization funds across the board.  Growth stocks significantly outperformed value stocks over the past decade, while maintaining without meaningfully higher levels of risk.

Annualized Return, 2002-2012
Value Blend Growth
Small 7.66% 8.27% 8.42%
Mid-Cap 8.08% 8.89% 8.55%
Large 5.98% 6.99% 7.85%
Annualized Return, 2002-2012
Value Blend Growth
Small 7.66% 8.27% 8.42%
Mid-Cap 8.08% 8.89% 8.55%
Large 5.98% 6.99% 7.85%

 

Summary Table

U.S. Mutual Fund Realized Returns & Risk, 2002-2012
Return Risk Risk-Adjusted Return
Active Index Active Index Active Index
U.S. EQUITY: SIZE & STYLE
Large Value 5.97% 6.64% 16.52% 18.04% 0.36 0.37
Large Blend 6.89% 7.16% 17.28% 17.22% 0.40 0.42
Large Growth 7.87% 7.38% 17.93% 16.97% 0.44 0.43
Mid-Cap Value 8.08% 7.40% 19.43% 20.38% 0.42 0.36
Mid-Cap Blend 7.64% 9.89% 21.93% 20.52% 0.35 0.48
Mid-Cap Growth 8.55% 7.34% 20.72% 19.38% 0.41 0.38
Small Value 7.50% 9.24% 21.65% 21.75% 0.35 0.42
Small Blend 7.36% 10.20% 21.20% 21.84% 0.35 0.47
Small Growth 8.19% 11.10% 21.67% 22.36% 0.38 0.50
U.S. EQUITY: RISK-TOLERANCE
Aggressive Allocation 6.14% 4.88% 15.15% 13.27% 0.41 0.37
Moderate Allocation 6.26% 6.56% 12.23% 10.34% 0.51 0.63
Conservative Allocation 5.20% 4.06% 11.54% 7.94% 0.45 0.51
FOREIGN
Foreign Small/Mid Blend 8.26% 7.92% 18.35% 27.16% 0.45 0.29
Foreign Large Blend 6.06% 8.38% 22.03% 21.81% 0.27 0.38
Europe Stock 8.05% 7.81% 21.49% 23.73% 0.37 0.33
Diversified Emerging Mkts 13.31% 15.87% 25.30% 26.37% 0.53 0.60
Diversified Pacific/Asia 7.27% 7.79% 22.90% 19.55% 0.32 0.40
GOVERNMENT BOND
Long Government 4.67% 5.45% 12.75% 24.09% 0.37 0.23
Intermediate Government 2.80% 2.83% 3.12% 5.24% 0.90 0.54
CORPORATE BOND
Long-Term Bond 4.65% 4.80% 9.36% 9.70% 0.50 0.49
Intermediate-Term Bond 3.28% 3.06% 4.51% 3.51% 0.73 0.87
Short-Term Bond 2.08% 2.30% 3.42% 2.31% 0.61 1.00
OTHER
Real Estate 7.92% 9.65% 26.02% 26.53% 0.30 0.36
Bear Market -6.69% -10.46% 24.56% 15.86% (0.27) (0.66)
Retirement Income 4.48% 3.72% 7.47% 4.67% 0.60 0.80
*All numbers are asset-weighted

 

Methodology

Price data was obtained from official providers (below) for all U.S. mutual funds in existence as of December 31, 2012.  The data set was trimmed to remove funds that had not been in existence for at least 10 years.  Quarterly returns were used to calculate annualized volatility.  Unless otherwise stated, all calculations of return, risk, and fees are asset-weighted.

Data Sources:

  • NASDAQ OMX
  • NYSE Euronext
  • FTSE
  • Chicago Board Options Exchange
  • Dow Jones
  • Standard & Poor’s
  • Deutsche Borse Group
  • Hang Seng Indexes
  • Nikkei
  • SIX Financial Information
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  • BMalkiel

    Two things: As Brycenesbiit points out, the after tax-return would have played out hugely in this study and made active managers way worse off in performance. This is especially true if one were to compare just about any ETF vs a comparable active manager. Second, this study is only for ten years, and while for some ten years seems like a long time, it’s not. I have looked at countless studies as an economist and have spoken to the researchers who’ve conducted them. Almost all studies show that when you reach the 15 and 20 year points, the percentage of managers beating active is in the single digits- usually only 10 or so actual managers! Moreover, as Sharpe has pointed out, there is absolutely no evidence indicating why one active manager beats another. That is, a monkey to do the same, worse, or even better. The decision about who to choose is not really subjective: hands down passive is superior as has been borne out by all the data. This study would have shown it too had it extended the time horizon.