Investors eager to join the rush from active funds to passive products may want to take a step back.
Not that investors don't have reason to shy away from active funds. They are expensive and their managers are so unpredictable that they struggle to keep up with their indices, according to the 2016 Mid-year S&P Dow Jones Indices Active Manager Versus Index (SPIVA) Scorecard. But research by American Funds calls some of the scorecard’s assertions into question, arguing that it's possible to identify and focus in on a select group of active managers who show consistently positive results.
Moreover, American Funds argues that managers who have lower fees and have skin in the game are more likely to beat their benchmarks.
The most recent SPIVA report, covering the first half of 2016, seems to tell a pretty clear story: The S&P 500 gained 3.99 percent year-over-year as of June 30, but nearly 85 percent of large-cap equity managers underperformed the index.
The bulk of SPIVA’s evidence shows that advisors and investors have a better chance of success from using simple, index-based strategies than they would from actively managed funds, says Preston McSwain, founder of Fiduciary Wealth Partners, a New York-based RIA that primarily employs passive funds in its investing strategies.
“The evidence is pretty clear that index funds add a lot of value as compared to a majority of active funds over many time periods,” says McSwain.
Active mid-cap and small-cap equity managers fared even worse than their large-cap bretheren—nearly 88 percent of mid-cap managers failed to match the performance of the S&P MidCap 400 index, and almost 89 percent of small-cap managers couldn’t beat the S&P SmallCap 600 index. In general, the SPIVA research showed that active managers were more likely to underperform as the investment horizon increases.
Why then would anyone want to invest in an active fund, typically more expensive and opaque than passive index funds?
For one thing, the SPIVA report doesn’t reflect how advisors and investors use active funds, says Steve Deschenes, product management and analytics director at the Capital Group, parent company of Los Angeles-based American Funds.
“It’s a mistake to focus on an equally weighted analysis of all active managers,” says Deschenes. “What really matters is whether investors and advisors can identify the 20 percent of active managers who are going to outperform in advance and benefit from that analysis. Looking at every actively managed funds, we can see that there are cohorts of managers who consistently do better. We have to find factors that reliably identify those managers.”