Active vs. Passive Investment Management

"A Random Walk Down Wall Street" Revisited

As an economics major at a small, midwestern liberal arts college (The College of Wooster) during the 1970’s, I had very little coursework that could be described as applicable to getting a job after I graduated (unless of course I wanted to be an economist!). However, I took one capital markets course that had as a core reading, “A Random Walk Down Wall Street”, by Burton G. Malkiel. I found this material to be especially fascinating and I enjoyed Professor Malkiel’s colloquial writing style. The book piqued my interest, leading to a 40-year career in the institutional capital markets.

The key tenet of the book, the random walk, leads to the conclusion that active managers of equity portfolios are highly unlikely to beat their indexes consistently, over the long run, especially after the deduction of their fees and other costs. As the exchange-traded fund (ETF) market has come to fruition, index returns (the same indexes active managers have been unable to outperform consistently) are available to all investors for a small fraction of the cost of an actively managed fund.¹ I’ve invested my own money with this premise in mind since the inception of the ETF market, and now have joined an advisory firm dedicated to the same principles. So, what is a random walk and what are the implications and opportunities for today’s investors?

Turning to Wikipedia for our definition, “The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk (so price changes are random) and thus cannot be predicted. It is consistent with the efficient-market hypothesis (EMH).” EMH states that stock prices reflect all available information, making it impossible to beat the market consistently on a risk adjusted basis. I believe this effect has been made all the more potent with the advent of the information age, where all public information is available to everyone, almost instantaneously.

The active vs. passive management debate has raged for years, but fortunately there is a depth of empirical evidence to evaluate. S&P Dow Jones Indices, LLC publishes their SPIVA U.S. Scorecard annually, which compares active managers’ returns to those of the various S&P indexes. Table 1 below is extracted from the 2020 report highlighting 18 equity categories. The numbers in each row indicate the percentage of U.S. equity funds in each category unable to beat the appropriate benchmark index. There are five time periods indicated, covering the short and long term, all measured through year-end 2020. The results are both telling and rather consistent. Remember, the bigger the number in the table, the worse active managers did relative to the indexes (e.g. The first cell indicates 57% of all domestic [U.S.] funds underperformed the S&P Composite 1500 index return for the one-year period ended December 31, 2020).

Table 1 – Percentage of U.S. Equity Mutual Funds Underperforming S&P Index Return

Source: S&P Dow Jones Indices LLC. As of December 31, 2020.

There are a few key takeaways from this table. Scanning the one-year column, you can see it was quite a mixed bag last year. Small-cap growth managers had an excellent year relative to the S&P SmallCap 600 Growth index, with only 13.7% of funds unable to beat the benchmark. On the other side of the coin, just over 80% of mid-cap core managers failed to beat the index return investors could have received for a small fraction of the fee. Of the 12 categories in the Growth, Value and Core buckets, 6 reflected outperformance by more than 50% of the managers in 2020. A roughly 50% chance of winning isn’t very good, but the story gets even worse for active management the further out you look.

Reading from left to right across each row, you will see the numbers get progressively higher in all but a few instances. This validates the difficulty managers have consistently beating market indexes in the long run. As one might expect, in any given year, active managers in some categories are likely to achieve a degree of success. However, as time passes, the random walk principle asserts itself and, combined with the impact of higher fees, pulls the long-term number of outperformers closer and closer to zero.

This factor makes it difficult, if not almost impossible, for the average investor to select an asset manager that will outperform consistently and for the long term. Further, what happens frequently instead is that investors select the manager that did really well last year, only to be disappointed further down the road with a less than stellar outcome.² Let’s look at some actual performance numbers for active managers against the S&P 500 to quantify the magnitude of underperformance we are talking about.

Table 2 below is also drawn from the 2020 SPIVA U.S. Scorecard. The format is the same as Table 1, but instead this table presents the actual, average annualized returns (after fees) generated by over 200 active managers of large-cap core funds, relative to the returns generated by the S&P 500 for the same periods.

Table 2 – Annualized Asset-Weighted Performance - U.S. Large Cap Core Funds

Source: S&P Dow Jones Indices LLC. As of December 31, 2020.

You can see that in none of the presented measurement periods did active management, on average, beat the passive return generated by the comparable index. 2020 was particularly difficult for this group of managers, but over the various longer time frames the magnitude of underperformance ranged from -0.57% annually, to -2.77%.³ This level of consistent underperformance is significant for sure, but compounding this level of underperformance year over year makes the deficit all the more daunting. Considering the better returns from passive management, why pay the significantly higher cost of active management?!

The advent of the ETF market makes passive, or indexed, investing available to all investors. Each ETF owns every stock in the corresponding index, in the same proportion as the index, so the investor gets a highly diversified portfolio with one vehicle. Liquidity is excellent as well with the ability to buy or sell as you would any stock during market hours. This combination of liquidity, diversification, low cost, and better relative performance is the reason we are advocates for ETF usage by all investors, large and small.

Notes:
1. While fees charged by active managers have continued to drop over time, perhaps due to the competitive pressure exerted by index funds, they are still much higher on average than index fund fees. For example, according to the Investment Company Institute’s 2021 Fact Book, the weighted average expense ratio for active equity mutual funds was 0.71% in 2020, while the weighted average expense ratio for equity index mutual funds was 0.06%.

2. S&P Dow Jones also publishes an annual evaluation of performance persistence among active fund managers. The 2020 edition and prior editions have consistently shown that it is extremely difficult for managers to maintain performance in the top quarter or even top half of their peer group over longer measurement periods.

3. Results for the other 17 equity categories were in some cases better and in some cases worse than those for Large Cap Core, depending on the asset class and measurement period examined. However, in only two cases was the asset weighted 10-year return of active managers above the selected benchmark, and in most cases, the managers trailed by 1-2% annually.