Just came across this chart from Russell Investments, which corroborates much of the data from last week’s post. Thus, the conclusion remains the same: it is very, very difficult to beat the indices in domestic large-cap equities.

This post will look at US large caps through the lens of the active vs passive debate. As one the largest and best known asset classes, it is often the battleground of the debate.

There is no shortage of analysis and reporting purporting to shed light on the active vs passive debate, although most of it is noise. SPIVA publishes data quarterly, although knowing what percent of managers out/underperformed each quarter or year is meaningless, as is knowing the persistence of top ranked funds (see here). So, we’ll skip all the noise and red herrings and skip right to a good starting point: rolling returns over multiple years.

The below shows that active managers really underperformed in 1990s, then enjoyed a period of outperformance during the recession of the early 2000s, but have not added much value since.

The picture does not change much when we go from 3-year rolling returns to 5-year rolling returns. The median manager added modest value for a brief time in the mid-2000s and again around 2010.

Vanguard put out this beautiful chart of 10-year rolling returns that includes data on all percentiles of active managers (instead of just the mean or median manager). On average, most active managers underperform over most 10-year time periods. Again, this is before taxes, so the real after-tax numbers are even worse for active managers.

There is some evidence that active managers perform better in severe down markets, which you can see in the above charts as well as in the scatter plot below. It’s is debatable whether this is simply due to lower equity allocations or whether active managers are successful risk managers. Distinguishing between those two factors is really just splitting hairs, so I’ll move on and wrap up.

Conclusions:

The data largely shows what the passive camp already knows: large cap indices are hard to beat. Over 3-, 5-, and 10-year periods, most active managers underperform most of the time.

However, the active camp will rightfully point out that there have been some time periods when more than half of managers outperform. This is true, although it is a minority of the time and does not include tax drag.

Of course, these numbers are in aggregate. Some managers may pitch themselves with a superior 10-year return and my hope is that readers will respond by saying, “Show me a history of your rolling returns.”

My final conclusion is that outperforming a US large-cap index is very, very difficult to do. It is even more difficult in taxable accounts. I don’t think its impossible and I own an actively-managed US large cap fund at the moment, but investors need a very compelling case because the odds favor passive management.

My general view (explained here) is that investors should use passive strategies in asset classes where it is difficult to beat the averages and active strategies where it is probable that the averages can be beat. Unfortunately, the active vs passive debate in many asset classes hinges on biases, dogma, and platitudes. Anecdotes and misused statistics abound, while rigorous questioning and examination are much harder to find.

Below are some questions that are commonly asked when evaluating whether active management can succeed in a particular asset class. Each is problematic in some way and also used (and the answers overplayed) by both the passive and active camps. Hopefully, the below is helpful in cutting through the BS and developing a framework for evaluating management style.

1. How many managers beat their benchmark in any given year?

The problem with the above question is that it is impossible to separate luck from skill. The number is likely to be higher in markets with higher volatility or more randomness. Therefore, we might ask:

2. How many of this year’s outperforming managers beat the market in consecutive years?

On the surface, this is a good question. However, it completely ignores the magnitude of outperformance or underperformance. Is it better for someone to gain 5% three years in a row or to get two years of 12% and one year of -2%?

3. We can look at active manager alpha over rolling 3-, 5-, 10-year periods, which should account for magnitude of gains of losses and focus on total return.

Yet, like any of the previous metrics, rolling returns vary over time. A particular manager or strategy might do well in one 10-year period and terrible in another. However, the data may show that it is consistently easy or difficult to outperform in a given asset class consistently through various regimes.

This is also a good place to pause and point out that questions #1-3 may lead to an aggregated answer, but can miss pockets of persistent outperformance. For instance, it is possible for subset of managers to consistently outperform in markets even if most underperform. That’s why #4 is important.

4. Shifting from asset classes to individual managers, it’s best to dig into the portfolio’s historical data and understand what drove performance in past years. This process is called “return attribution.”

Reviewing past performance and attribution is helpful, but certainly not prescriptive. Evaluating portfolio construction, strategy, historical returns and attribution provides a baseline understanding, but portfolios evolve over time and the future will inevitably unfold differently than the past. However, investors can understand a manager’s process and judge whether the returns were due to skill or luck and, ultimately, whether past success is repeatable or not.

The above is just a brief summary of some commonly asked questions and why they are problematic. As I mentioned, hopefully it is helpful in calling someone’s BS. We’ll dig deeper into specific asset classes over the next few weeks.