It’s commonly recognized that the average active manager underperforms the market. There are good theoretical reasons why this should be true, and ample empirical evidence that it is true. On average during the last ten years, e.g., 59% of large-cap U.S. equity managers lagged the S&P 500, with comparably poor results for mid- and small-cap specialists.
Capitalization-weighted indices like the S&P 500 have a number of virtues, the most important of which for present purposes is that they tell us the return of the average dollar invested. Sharpe’s conclusion that “the average actively managed dollar must underperform the average passively managed dollar, net of costs” thus explains (among other things) the results of our SPIVA scorecards.
But cap-weighted indices do not tell us the return of the average stock. If we want to know the average stock’s performance, we can learn it by observing the return of an equal-weight index. Over time, equal-weight indices have outperformed their cap-weighted counterparts — an unsurprising result since equal-weight indices are mathematically certain to have a lower average capitalization, and there’s a well-known tendency for smaller stocks to outperform larger stocks.
Now, suppose we pick stocks at random, choosing from the constituents of the S&P 500. What return should we expect? With enough trials and enough time, random selection will produce the return of the average stock in the index. That means that the best estimate of the return of a randomly-selected portfolio is the return of an equal-weight index.
The dozen years since we began issuing SPIVA scorecards are a period in which the equal-weight S&P 500 decisively outperformed the cap-weighted index. The underperformance of the average active manager is therefore especially striking — since the average randomly-selected portfolio would have readily outperformed. This has two implications for those who employ and evaluate active managers:
- Comparing active performance to an equal-weight benchmark can be a valuable complement to any portfolio review. Arguably, any alpha-generating process worth its salt should be able to outperform random selection — which is to say, should be able to outperform an equally-weighted index.
- Since most active managers haven’t outperformed equal weight, it follows that, as a group, their performance is even worse than you think.