Performance Studies & Commentaries
These performance studies provide consistent evidence over the past century that index funds deliver better results than active funds. Wall Street has adapted its spin to defend its profit stream at investors’ expense. As the measurement tools have gotten more sophisticated the common sense intuition has held true: the low-cost advantage of index funds provides superior odds for your investment success.
1. 1928-1932 – Cowles Commission (Four Studies in 1933); updated report (1944)1Alfred Cowles III, “Can Stock Market Forecasters Forecast?” Econometrica 1 (July 1933): 309–324. 3. Alfred Cowles III, “Stock Market Forecasting,” Econometrica 12, no. 3–4 (July–October 1944): 206–214.
Study # 1: Weekly stock purchase recommendations of 16 established financial services firms; approximately 7,500 forecasts.
• Performance average for the 16 services was 1.4 percent below the Dow Jones Industrial Average; 6 services outperformed the average; 10 underperformed.
• Loss-win ratio: about to 2:1.
Study # 2: stock investment records of 25 large fire insurance companies whose investment policies were based on “the accumulated knowledge of successive boards of directors whose judgment might be presumed, over the years, to have been well above that of the average investor.”
• Performance lagged the Dow (DJIA) by 1.2 percent per year; of 20 insurance companies analyzed, 6 portfolios outperformed; 14 underperformed.
• Loss-win ratio: about 2:1.
Study #3: Forecasts for stock market performance made by 24 investment newsletters.
• Performance lagged Dow by 4% if investors had followed all of them with equal amounts of initial capital allotted to each; 8 out of the 24 had returns higher than the market and 16 lower returns.
• Loss-win ratio: exactly a 2:1.
Study #4: Market timing strategy called Dow Theory, named after its founder, Charles Dow. The data followed the predictions of Dow’s predecessor, William Hamilton, from 1904-1929.
• Performance lagged the Dow by 3.5% per year over the 26-year period.
• In all, Hamilton made 90 different market calls to be either long, short, or all in cash; 45 were profitable, 45 were unprofitable. Otherwise known as a coin toss!
Study #5: 1944 Update: using 11 of the original 24 forecasters; 6 of the 11 outperformed the market by 0.2%; however, survivorship bias was not measured (those firms who went out of business were deleted from the results) overstating actual results
2. Bogle’s Thesis: The Math Behind Winners and Losers (1951)2John C. Bogle, “The Economic Role of the Investment Company” (undergraduate thesis, Princeton University Department of Economics and Social Institution April 21, 1951), 19. Includes further reference to Securities and Exchange Commission, Investment Trusts, and Investment Companies, p. 508. 5.
Bogle, “Economic Role,” 27. 6. Ibid., 19. 7.
The 1929-1936 study of the mutual fund industry found 49 funds that lagged the market by 0.70%; returns in later years also showed no demonstrated pattern or skill in beating the market. Bogle’s conclusion: winners and losers cancel each other out. For every investor who outperforms before expenses, one must underperform (it’s a coin toss!). After expenses, the aggregate will lose due to the simple math.
3. Harry Markowitz: The Important Relationship of Risk and Return Quantified (NOBEL PRIZE)3Harry Markowitz. “Portfolio Selection,” The Journal of Finance 7, no. 1 (March 1952): 77–91. 8.
In the 1950’s this groundbreaking work explored the relationship/tradeoffs of portfolio risk and return. His work showed a direct correlation between risk and return, and that managing risk is important: “. . . the investor should consider expected return a desirable thing and variance of return [i.e. risk] an undesirable thing.” Markowitz’s basic theory is that a portfolio is efficient if no other portfolio provides either (1) a higher expected return and the same risk or (2) a lower risk and the same expected return.
4. William Sharpe: Stock Risk vs. Market Risk – Beta is Born (NOBEL PRIZE)4William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” The Journal of Finance 19, no. 3 (1964): 425–42. 11.
Sharpe’s work with portfolio theory centered on understanding individual security risk (non-market risk) versus market risk. The “beta” of a stock or bond (portfolio of stocks and bonds) is measured against the beta of the market. The market beta is by definition 1.0; stocks/portfolios with a beta less than one are less risky; those with beta greater than one are riskier. The more broadly diversified a portfolio becomes the less it will be vulnerable to non-market risk factors. Sharpe, like Bogle, concluded that for every winner, there must be a loser, before expenses.
5. Eugene Fama: Efficient Market Theory and Prices (NOBEL PRIZE)5Eugene Fama, “The Behavior of Stock Market Prices,” Journal of Business 38, no. 1 (January 1965): 34–105. 9. Ibid., 92. 10.
Fama’s research hypothesized that all known and available information is reflected in security prices; therefore, the only way to capture excess return is by taking greater risk or having access to inside information. He reviewed domestic equity mutual funds that had at least 10 years of performance from 1951-1960, and subsequently did a larger study from 1984-2006. Both studies had 2:1 loss-win ratios. Fama teamed with Ken French and they formed a three-factor model based on a market factor (beta), size, and value to evaluate fund performance. Their findings demonstrated that these three factors explained 95% of fund performance, leaving very little room for active management to outperform, and that with fees and expenses the chance of outperformance was minimal.
6. Jack Treynor and Michael Jensen: Tools to Measure a Fund’s Risk6Jack L. Treynor, “How to Rate Management of Investment Funds,” Harvard Business Review 43 (1965): 63–75. 12. ,7Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” The Journal of Finance 23, no. 2 (1967): 389–416.
Jensen, Treynor (and Sharpe) agreed that portfolio return should be risk-adjusted to accurately assess a manager’s skill. Riskier portfolios should have higher returns than less risky portfolios. A manager shouldn’t be credited with outperformance skill because they took more risk. Jensen’s Alpha, the Treynor Ratio, and the Sharpe Ratio all gauge return against risk and produce similar results. Jensen studied 115 surviving fund returns from 1945-1964. The average fund earned 1.1 percent less per year than the S&P 500, lower than the expected return given the average fund’s risk level as measured by its beta. This means the average fund manager didn’t generate alpha. Net of fees and risk-adjusted, 39 surviving funds beat the market; that’s a 2:1 loss-win ratio. The median winning fund outperformed the market on a risk-adjusted basis by 0.6 percent; the median losing fund underperformed the market by 1.6 percent. Jensen’s study led to the disclaimer, “past performance is no guarantee of future performance.”
7. Burton Malkiel: Random Walk Down Wall Street8Burton Malkiel, A Random Walk Down Wall Street, (New York: W.W. Norton, 1973).
Malkiel’s book opened the public’s eyes with a clear message. Backed by various studies individual investors could now understand how the mutual fund industry put the odds against them. Malkiel showed the advantages of index funds and made pleas to mutual fund companies to sponsor them. He noted that “fund spokesmen are quick to point out you can’t buy the market averages. It’s time the public can.”
8. Charles Ellis: The Loser’s Game9Charles D. Ellis, “The Loser’s Game,” Financial Analysts Journal 31, no. 4 (1975).
Ellis noted big changes in the period 1965-1975. Institutional market share grew from 30% to 70% and came to dominate activity; portfolio turnover increased from 10% to 70% as the active fund industry tried to live up to its new marketing message of “beating the market.” Ellis noted that institutions now were “the market.” How can you beat the market if you are the market? Add fees and trading costs and the probabilities work further against the investor. Therefore, he dubbed the “beating the market” premise as a “Loser’s Game.”
Ben Graham, Warren Buffet’s mentor, and ‘father of value investing’ also noted the change, “I am no longer an advocate of securities analysis in order to find superior value opportunities….the situation has changed. I’m on the side of the efficient market school of thought.”
9. Bogle Again: Vanguard, the Birth of Index Funds: Debunking the “Myth of Average!”
The Vanguard 500 Index Fund launched in late 1976. The active fund industry was quick to react and tarred “Bogle’s Folly,” with the “myth of the average.” Who wants to be an average golfer? The math behind the myth is flawed. Fact is, due to low implementation costs, index funds invariably rise to the top 50%, and as active managers often fall into lower quartile ranks, indexing rises further in the rankings near the 65%-85% as we have seen in the studies (and in my own experience with fund reviews). Being in the top quartile is much better than average! In fact, it’s more accurate to call this “par” performance – well above the average golfer! Typically, near the top quartile. The odds win. What’s your handicap?
10. Mutual Fund Persistent Underperformance?10Mark M. Carhart, “On Persistence in Mutual Fund Performance,” The Journal of Finance 52, no. 1 (March 1997): 80.
Mark Carhart incorporated momentum into the Fama-French Three Factor Model to create a four-factor model and analyzed the performance of 1,892 funds from 1961-1993. After adjusting for beta, firm size, style, and momentum factors, Carhart concluded that an equal weighted portfolio of the mutual funds underperformed by 1.8 percent per year for the period covered (close to the funds fees and expenses). He concluded the evidence was consistent with market efficiency. Top-decile funds earned back their investment costs, most funds underperformed by about their investment costs, and bottom-decile funds underperformed by about twice their investment costs. A lot of bother for nothing.
11. Warren Buffet: 1996 Annual Letter to Shareholders
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expense) delivered by the great majority of investment professionals. Seriously, costs matter.” The world’s most famous investor knows the importance of cost in the investment equation.
12. The Vanguard Study: Active Management vs. the Index (1984-2009)
The 25-year Vanguard 500 Index vs Active study gives us the 2:1 loss-win ratio again (Vanguard beat 66% of total funds), before adjusting for terminated funds, risk, sales loads, and taxes. According to Lipper, of the 260 actively managed domestic equity funds available when Vanguard 500 launched in 1976, about half closed or merged over the years, leaving 136 surviving funds as of December 2009.
13. The Vanguard Study: Active Management vs. the Index (1984-2009)
If the closed funds had been included in the study, Vanguard beat 85% of its active competitors, moving toward 90% when factoring in risk, taxes, and sales loads. The average underperformance from the losing funds was greater than double the outperformance of winning funds; the winning fund payout was about 30% of what would be expected. Investors weren’t compensated for the additional risk.
14. Swiss Finance Institute
A paper published by the Swiss Finance Institute entitled “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” attempted to quantify the number of skilled managers against lucky managers. The research set was a database of 2,076 U.S. equity mutual fund returns over the 1975 to 2006 period. The authors’ conclusion was that only 12 fund managers exhibited skill over this time period.
15. Warren Buffet Again: 2013 Annual Letter to Shareholders (Warren Can’t Find another Warren)
“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will………My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
16. Standard & Poor’s (SPIVA) and Morningstar (BSR)
The S&P Indices Versus Active (SPIVA) report, tracks 1, 3, 5, 10, and 15-year performance across multiple asset classes. Derived from a survivorship-bias-free database, index funds outperform the average active fund in every asset class over long time periods. There are periods when active funds outperform, but not by much and not for long. Over a complete market cycle active mutual funds outperform indices about one-third of the time or more, consistent with the 2:1 loss-win ratio in the other performance studies.
Morningstar’s Box Style Report (BSR) likewise compares active fund performance against indices. The BSR results find that after adjusting for three-factor risk, the active funds on average underperformed by just about the fees they charged. Consistency again! Sharpe noted in 1991, that “properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs.”
Performance Studies & Commentaries: Observations & Perspective
Studies 3-6 include three Noble Prize-winning discoveries that were important developments in the analysis and measurement of performance because they helped investors to understand risk as it related to return, thereby enabling a more accurate and relevant way to compare investment results. These tools help scrutinize outperformance claims. If a fund manager makes risky bets to beat the market (as they must), it’s vital to understand return potential against risk of loss (both how much and how often). As noted, these bets rarely pay off for the risk incurred.
Even as data analysis has gotten more sophisticated, the loss ratio has stayed remarkably consistent. The trends that Ellis observed in 1974 have only increased. Institutional dominance has grown, thereby further decreasing the odds that market inefficiencies can be exploited for profit.
Jerry Matecun – Founder, President
Expert guidance to plan your future, preserve your lifestyle, and retire with confidence. For a confidential consult, contact me at jerry@compoundvalue.com.
FOOTNOTES
- 1Alfred Cowles III, “Can Stock Market Forecasters Forecast?” Econometrica 1 (July 1933): 309–324. 3. Alfred Cowles III, “Stock Market Forecasting,” Econometrica 12, no. 3–4 (July–October 1944): 206–214.
- 2John C. Bogle, “The Economic Role of the Investment Company” (undergraduate thesis, Princeton University Department of Economics and Social Institution April 21, 1951), 19. Includes further reference to Securities and Exchange Commission, Investment Trusts, and Investment Companies, p. 508. 5.
Bogle, “Economic Role,” 27. 6. Ibid., 19. 7. - 3Harry Markowitz. “Portfolio Selection,” The Journal of Finance 7, no. 1 (March 1952): 77–91. 8.
- 4William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” The Journal of Finance 19, no. 3 (1964): 425–42. 11.
- 5Eugene Fama, “The Behavior of Stock Market Prices,” Journal of Business 38, no. 1 (January 1965): 34–105. 9. Ibid., 92. 10.
- 6Jack L. Treynor, “How to Rate Management of Investment Funds,” Harvard Business Review 43 (1965): 63–75. 12.
- 7Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” The Journal of Finance 23, no. 2 (1967): 389–416.
- 8Burton Malkiel, A Random Walk Down Wall Street, (New York: W.W. Norton, 1973).
- 9Charles D. Ellis, “The Loser’s Game,” Financial Analysts Journal 31, no. 4 (1975).
- 10Mark M. Carhart, “On Persistence in Mutual Fund Performance,” The Journal of Finance 52, no. 1 (March 1997): 80.
PLEASE NOTE: Nothing herein constitutes investment, legal, or tax advice. For details please see Disclosure.
