The consistent conclusion of studies dating back nearly 100 years is that most active managers underperform passive benchmarks appropriate to their investment style. Charles Ellis famously characterized active management as a “loser’s game” in 1975, a year after Nobel laureate Paul Samuelson urged that “some large foundation should set up an in-house portfolio that tracks the S&P 500 Index”. 

Since 2001, our firm has contributed to the comparative study of active and index performance by issuing SPIVA® (S&P Index vs Active) reports. Figure 2 documents the underperformance of large-cap US managers.

 

Results are similar outside the US, including in the Asia-Pacific region: most active managers underperform most of the time. Moreover, when outperformance occurs, it tends not to persist. Managers who were above average last year are not more likely to be above average this year than their underperforming counterparts.

These observations cry out for an explanation. After all, active managers are smart people who are usually well-educated, hard-working, and properly incented to outperform. Three factors help explain why active management disappoints more often than not.

 

Lower cost is the simplest explanation for the success of passive management. Imagine a market in which all assets are actively managed, and into which a passive alternative is suddenly inserted. Since the index fund buys a pro-rata share of every stock’s capitalization, its portfolio will be identical to the aggregate portfolio of the active managers. Before costs, therefore, the index and active portfolios will have the same return.

However, active managers’ costs — for research, trading, management fees, etc —are inherently higher than those of passive managers. Thus, “properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs”.

 

Investment management is a zero-sum game. There is no natural source of outperformance; the outperformance of above-average investors is offset by the underperformance of below-average investors. “Investors” in this sense encompass not just professional money managers, but any owner of securities.

Consider, for example, a conservative investor who owns a few high-quality, dividend-paying electric utility companies because he values their relatively secure income stream. Such an investor is a potential source of outperformance for every professional manager who is underweight utilities. If professional investors represent a relatively small fraction of a market’s assets, such undiversified amateurs can be an important source of the professionals’ outperformance.

However, if professionals become the dominant force in a market and amateur investors are relatively unimportant, the game changes — the professionals are now competing against each other. By the 1970s, the US market had become largely institutionalized. That’s why the move toward index investing started then, rather than 10 years earlier or 10 years later.

 

The skewness of stock returns is an underappreciated element in the performance difficulties of active managers. Consider Figure 3, which shows the distribution of Asian stock returns for the last 20 years.

The median return in this distribution was -9%, but the average was +99%. An active manager trying to select a portfolio from a positively-skewed return distribution is obviously handicapped: there are many more below-average stocks than above-average stocks. And skewed returns are the rule, not the exception, in every market of which we’re aware.

Active underperformance, therefore, is not a coincidence but a consequence of costs, professionalization and skewness. As these factors are likely to continue, investor acceptance of indexed portfolios should continue and grow as well.

 

Craig Lazzara is managing director and global head of Index Investment Strategy at S&P Dow Jones Indices.