More evidence on the superiority of index investing — most active fund managers can’t even beat a blindfolded monkey

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In two recent articles in the New York Times Your Money section, business editor Jeff Sommer wrote about the superiority of passively managed index funds over actively managed funds. Sommer cites a June 2014 study by S&P Dow Jones Indices titled “Does Past Performance Matter? The Persistence Scorecard,” which provides some new, recent evidence that bolsters the case for investing in passively managed index funds.

Here’s an excerpt from Sommer’s first article on July 19 “Who Routinely Trounces the Stock Market? Try 2 Out of 2,862 Funds” (emphasis added):

The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn’t guarantee future returns.

The S&P Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)

The team selected the 25% of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07% of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

The study sliced and diced the mutual fund universe in a number of other ways, too, each time finding the same core truth: Very few funds achieved consistent and persistent outperformance. Furthermore, sustained outperformance declined rapidly over time. And the report said, “The data shows a likelihood for the best-performing funds to become the worst-performing funds and vice versa.

What should investors make of these findings? There is one clear implication, said Keith Loggie, senior director of global research and design at S&P Dow Jones Indices.

“It is very difficult for active fund managers to consistently outperform their peers and remain in the top quartile of performance over long periods of time,” he said. “There is no evidence that a fund that outperforms in one period, or even over several consecutive periods, has any greater likelihood than other funds of outperforming in the future.”

This seems to bolster the case for index-fund investing. After all, if a fund manager with a great year can’t be counted on to outperform other fund managers later, it’s reasonable to ask: Why bother trying to beat the market at all?

And here’s an excerpt from Sommer’s second article on July 26 “Heads or Tails? Either Way, You Might Beat a Stock Picker” (emphasis added):

Over the last five years, actively managed stock mutual funds have performed even worse than would have been predicted if the fund managers were flipping coins instead of picking stocks. The real-world statistics to which I’m referring were contained in a recent S&P Dow Jones Indices study that I summarized in last week’s column.

Briefly put, the results of the S&P study, “Does Past Performance Matter? The Persistence Scorecard,” were bleak enough on their own. They showed that very few mutual funds were able to consistently outperform their peers, and that those that did so in one given year were likely to be poor performers five years later.

In fact, only 2 out of 2,862 broad domestic stock funds were able to outperform their peers consistently over five years, according to one measure: performance in the top quartile of funds over five consecutive 12-month periods ended in March 2014. That’s an unimpressive performance, to be sure. And if you compare it with a series of coin flips — a series of random choices — it looks even worse.

The dismal results of the real-world fund managers were very close to what Burton G. Malkiel, the Princeton finance professor, once described as “a random walk.” “Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts,” he wrote in his guide to investing, “A Random Walk Down Wall Street.”

As a group, managers who ran the 2,862 funds examined by S.&P. Dow Jones Indices didn’t do as well as a blindfolded monkey. The hypothetical monkey, or a serial coin flipper, beat them in several other tests, too.

These findings may suggest that rather than spending a lot of time and money picking stocks or stock fund managers based simply on past performance, you might be better off just flipping a coin. And that implies investing in low-cost, diversified index funds.

MP: As I’ve mentioned before, the fact that 70% of US investors don’t own a single passively-managed index fund (and many of the 30% of investors who do own at least one index fund may not be using them as the core of their investment portfolios), despite the proven superiority of index funds over actively-managed funds represents perhaps one of the greatest “market failures” and “market inefficiencies” of our time. The stock market might be highly efficient, but the investing habits of a significant majority of investors remains highly inefficient in my opinion. Thousands and thousands of investors spend millions of dollars on fees and expenses every year for actively managed funds to collectively lose them billions of dollars compared to having the core of their portfolios in passively managed mutual funds…..

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