We examine the nature of skill in active management by asking whether active funds beat not just passive benchmarks, but the traded assets that represent the opportunity cost of active investments: index funds. Using the recent growth in the cross-section of index funds, we examine the entire distribution of actively managed funds. Our results are surprising. We find little evidence that active funds exhibit more skill than passive funds, even for top-performing funds before fees. On the other hand, the worst index funds fare far better than the worst active funds. If some active funds have skill, one must also conclude that some index funds do as well. Since the extent of index fund skill is limited, the same must be true for active funds. Our results cast doubt on traditional theories regarding skill in active management, as we also find strong evidence of a flow-for-performance relationship even among index funds.
What’s the value of active portfolio management? This question has been debated for decades and the consensus seems to be that active funds might exhibit skill, but after fees you’re just as well off owning an index fund.
So what is different about this paper? In the words of the authors:
We compliment this literature by comparing fund performance not to a simulated no-skill distribution, but to an economically appealing set of alternative funds that are actually traded. In a sense, we set a higher hurdle for skill. We show that both index funds and active managers appear to perform better than the simulated funds in some parts of the distribution, but that active funds still do not outperform passive funds.
In short, the authors compare active fund performance to tradeable index alternatives, whereas, historically, researchers compare active performance to theoretical no-skill funds.
Why look at index funds? In a perfect CAPM world there is only one index fund–an index fund that is value-weighted across all assets around the globe, or in the nomenclature of classic portfolio theory, the “market portfolio.” Of course, in reality there are thousands of index funds from which an investor can choose.
The authors in this paper address the active vs. passive question by comparing the bootstrapped distributions of traded index funds and active funds. They assume that the differences in active and index performance represent the value of active management.
The data sample consists of 2,153 distinct funds, 240 of which are passive index mutual funds or ETFs. In general, the passive vs. active funds can be characterized as follows:
Do not engage in stock picking;
Lower expenses— average expense ratio of 47 basis points;
Lower turnover— turnover of 24%.
Active managed funds:
Engage in stock picking;
Higher expenses— average expense ratio of 125 basis points;
Higher turnover— turnover of 74%.
The figure below plot the cumulative distribution functions (CDFs) of gross alpha for index and active funds in excess of S&P 500. More risks adjustments such as CAPM, Fama-French-Carhart, Vanguard, 7-factor and Ferson-Schadt can be found in Figure 1–all variations tell the same story:
Top-performing index funds have similar skill to the best active funds;
For below-median funds, passive funds generally outperform actively managed funds;
On net, index are similar–if not better–than their active counterparts…BEFORE fees!
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016).
Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.