Indexology^® Blog

What do presidential debates and an argument between passive and active investors have in common? They are both thrilling, demand the highest levels of rhetorical skills, don’t change audience opinions, and everyone goes home entertained. While presidential debates remain as exciting as ever, the shrillness of conversation between active and passive investors seems to have lessened. One could argue that this change is due to (1) a smaller degree of outperformance of star managers, (2) a convergence of fee differentials, and (3) the investment industry widening its focus to offer more solutions.

Performance

One of the drivers behind the shift in capital from active to passive is the question of active managers’ ability to outperform their benchmarks. Here, the burden of proof has fallen squarely on active managers. While there are, indeed, a few active managers who outperform, S&P DJI’s SPIVA® U.S. Scorecard[1] highlights that the last time the majority of all active U.S. managers outperformed was in 2013. In 2019, a full 70% of all active U.S. investors underperformed.

Based on the SPIVA Scorecard, some areas of the market are relatively easier for alpha generation than others. Over the past 10 years, on a net-of-fees basis, 63% of international small-cap (ISC) managers underperformed their benchmark, while the number for the U.S. large-cap core (LCC) was 97%. While there are periods of outperformance for a median manager, alpha is volatile and mostly negative (see Exhibit 1).

While the alpha generation of median managers is underwhelming, what about the best-performing investors? Let’s look at the top-quartile managers (see Exhibit 2). Identifying top managers a priori is, of course, unrealistic, and many strategies don’t survive—only 50% of LCC and 60% of ISC funds that existed 10 years ago are still live.[2] However, even with the benefit of perfect hindsight, what we want to analyze is whether we can discern any change in the magnitude of alpha for the best managers.

Top investors are still able to generate excess returns, although the downtrend is apparent, and persistence of this alpha is fleeting.[3]

Convergence of Fee Differentials

Many of us are aware of the pressure that active and, more recently, passive investors have been under with respect to the structural decline in fee levels. Technological and analytical advances contributed to increasing economies of scale and brought up a heightened investor focus on sources of performance. As fees continue to march lower (with the differential dropping by about one-third since 2000), the contrast between active and passive has become less pronounced (see Exhibit 3).SPIV

Both Passive and Active Are Focusing on Solutions

As healthcare and college costs continue to march higher, and as the burden of saving for retirement has shifted from employers to employees, the investment industry has repositioned itself. Managers are evolving beyond long-only, asset-class-specific strategies. Instead, outcome-based solutions such as target date funds, 529 plans, and income guarantee products have proliferated.

One can argue that the investment industry has morphed into a “manufacturing” industry: various solutions come to market that try to target a specific outcome. Contrast this with 10+ years ago, when many value propositions had to do with attempting to outperform a benchmark while maintaining a certain level of risk. Here at S&P DJI, we are actively engaging in providing index-based solutions such as our U.S. equity franchise, volatility indices, multi-factor and multi-asset approaches, thematic funds, ESG offerings, real assets, and custom indices.

Active and passive investors are opinionated groups. However, as the industry continues to shift and investment approaches evolve, we suspect that the two camps will continue to converge, heated discussions will become less so, and the focus will center more around providing appropriate solutions to investors regardless of the investment approaches.

[1] SPIVA U.S. Scorecard, Year-End 2019

[2] SPIVA Institutional Scorecard, Year-End 2018

[3] Soe, A., Can You Beat the Market Consistently?, 2019

Globally, as markets have matured, we have seen the institutional share of public equity increasing.[1] Professional managers are continuing to enter the investment management industry, resulting in market research becoming more institutionalized. Hence, more and more industry research analysts are competing against each other and chasing the same set of stocks to generate alpha (or excess returns over the benchmark). This has been one of the factors impeding active fund manager’s ability to exploit information asymmetry to generate alpha. A similar scenario seems to be unfolding in the Indian Equity Large-Cap category, where generating alpha is becoming increasingly difficult for active fund managers, as seen in the SPIVA India Scorecards over the years.

Each box in Exhibits 1a and 1b showcases the spread in alpha[2] generated by Indian Large-Cap Equity active funds in a calendar year. Exhibit 1a calculates alpha based on gross returns minus the S&P BSE 100 (TR) returns (benchmark for large-Cap funds in India), whereas Exhibit 1b is based on excess net-of-fees returns over the benchmark. The exhibits show that there is a wide spread in alpha generated by funds. Exhibit 1a shows that in each calendar year, a fairly large proportion of active fund managers failed to beat the S&P BSE 100 benchmark on a gross-returns basis, i.e., even without deducting management fees. The story looks even more dismal when we look at net alpha (Exhibit 1b), where the median active fund beats the benchmark in only 5 of 10 years.

Each observation in Exhibit 2a shows the distribution of yearly gross alpha for the large-cap category funds for each calendar year from 2010 to 2019,[3] and the gray line is the cumulative distribution curve of all the observations. Exhibit 2b shows the same based on net alpha. According to the gross return distribution in Exhibit 2a, almost 35% of the observations lie to the left of the vertical line that represents the “0% gross alpha.” In other words, 35% of the observations had negative gross returns. When we generate the same chart for net alpha, the distribution curve shifts to the left, with nearly 52% of the observations that lie to the left of the vertical line representing “0% net alpha.” Both charts show that alpha distribution is skewed to the right with a few outlier observations pulling the return alpha average values to the right, while the median values lie to the left of the mean values.

We also conducted a t-test (one-tail) to investigate if the gross alpha and net alpha are significantly greater than 0. Exhibit 3 shows that at a 95% confidence level, gross alpha is significantly greater than 0%. However, the same does not hold true for net alpha. In addition, the mean values exceed the median values for both the gross and net alpha, indicating the gross and net alphas are skewed positively by a few high return funds in the large-cap fund category. These results show the challenges of fishing for outperforming active large-cap funds over the long term.

The short answer to the question in the title of the blog is: quite nearly. With vanishing alpha, it may have long lasting implications for the active management industry where the most skilled managers survive and the funds that lie consistently on the left tail of the curve in Exhibit 2 would face strong challenge to grow or survive for long periods. Based on our SPIVA India Year-End 2019 Scorecard, 68.8% of funds in this category did not survive for the 10-year period ending in December 2019. With the competition that the increasing number of passive investment products brings, active fund managers may find themselves under pressure to generate higher gross alpha over the benchmark or to moderate costs and fees in an attempt to offer enhanced (net) alpha to investors.[4]

[1] https://www.oecd.org/corporate/Owners-of-the-Worlds-Listed-Companies.pdf

[2] Gross alpha = gross returns – benchmark returns; net alpha = net returns – benchmark returns; net returns = gross returns – management fees

[3] Therefore each large-cap fund (that survives and reports during the period from 2010 to 2019) will contribute 10 observations to the histogram. Only funds that survived and reported returns during the entire calendar year were considered for alpha calculations.

[4] This is analysis is inspired from an earlier research carried out by Vanguard for mutual funds domiciled in the U.S. https://personal.vanguard.com/pdf/ISGZSG.pdf

Without Fees, Do Active Managers Outperform their Benchmarks?

The SPIVA^® India Year-End 2019 Scorecard shows that, over longer horizons, a large proportion of active funds underperform their respective category benchmarks (see Exhibit 1a). The SPIVA India Year-End 2019 Scorecard evaluates the performance based on net-of-fees returns (i.e., gross returns less the management fees). But do active fund managers fare better when evaluated based on gross returns? In this blog, we have evaluated the results of the SPIVA India Year-End 2019 Scorecard on a gross-return basis (see Exhibit 1b). One can notice that in most categories, even without the deduction of management fees, still a fairly large percentage of active funds failed to beat their benchmarks. For example, over the 10-year horizon, more than 40% of active funds in the large-cap and mid-/small-cap categories underperformed the S&P BSE 100 and S&P BSE 400 MidSmallCap Index, respectively (see Exhibit 1b). Even the government and composite bond categories had over 65% of their funds underperform their respective benchmarks based on gross returns. An investor may therefore be wary of paying a management fee in return for worse-than-benchmark fund returns even on a gross-return basis.

Estimating Expense Ratios for Each Fund Category

Exhibit 2 shows the 10-year annualized gross and net-of-fees returns for each category on an equal-weighted basis, while Exhibit 2b shows the same but based on an asset-weighted basis (i.e., returns are weighted by funds’ AUM); Exhibit 2 reflects the returns for every dollar amount invested in that category. The difference between the gross CAGR and net CAGR is a proxy of the annualized management fees paid by investors during the 10-year period from Dec. 31, 2009, to Dec. 31, 2019. With this estimation, investors, on average, paid 230 bps annually in management fees in the Indian Equity Large-Cap category over the 10-year period. In the ELSS and mid-/small-cap categories, investors paid higher expenses to the tune of approximately 250 bps per year over the same period.

Does Alpha Generation Outpace the Management Fees Charged in Indian Equity Large Cap Active Funds?

To analyze if the alpha[1] generation of fund returns over the benchmark was consistent over the years for the Indian Equity Large-Cap category, we dissect the asset- and equal-weighted gross and net fund returns into calendar year performance. Exhibit 3 shows the calendar-year gross alpha (evaluated both on equal- and asset-weighted returns) for the Indian Equity Large-Cap category versus the benchmark S&P BSE 100. We see that on an average gross-return basis, fund managers delivered positive alpha for the majority of the years, though not consistently throughout history, with the worst relative performance seen in 2012, 2013, and 2018 (see Exhibit 3). Also in an earlier blog, we had evaluated in which phases of the market cycles it is more probable for fund managers to generate alpha and under which conditions they typically underperform.

The annualized gross return alpha in the Indian Equity Large-Cap category was around 256 bps and 220 bps on an asset-weighted and equal-weighted basis, respectively (see Exhibit 3). However, these return alphas would be eroded by the annualized management fee of 230 bps (as estimated earlier in this blog), and an average large-cap fund investor would be left with a net return alpha of only 27 bps and -10bps per year on an asset-weighted and equal-weighted basis, respectively.

In conclusion, the alpha generation by fund managers in the Indian Large-Cap Equity category were largely eroded by the fees they charged, resulting in marginal or even negative average net excess return over the long-term investment horizon compared to the benchmark. Even on a gross-return basis, a significant proportion of funds underperformed the benchmark, posing challenges on fund selection and investment style changes. As an outcome, we have seen growing assets in passive investment products, which tend to be more style consistent and cost effective.

[1] Gross alpha = gross returns – benchmark returns; net alpha = net returns – benchmark returns; net returns = gross returns – management fees.

How is COVID-19 relief impacting U.S. market segments? S&P DJI’s Gaurav Sinha takes a closer look at fixed income spreads, small- and mid-cap equities, and a potential role for the quality factor moving forward.

In early March 2020, S&P Dow Jones Indices released the SPIVA Australia Year-End 2019 Scorecard. With the market gyrations in late February and March due to the COVID-19 pandemic spreading across the globe, we decided to provide a “mid-term” SPIVA update to include data up to March 31, 2020, and to share the timely results through the webinar, Harnessing Active Vs. Passive Findings During Times of Market Turbulence. So, what did we find?

Q1 2020 Market Performance

With the exception of Australian bonds, all asset classes suffered drawdowns, with the S&P/ASX 200 seeing a drawdown of 23%. The S&P/ASX 200 A-REIT experienced a drawdown of 34.4%.

Q1 2020 Fund Performance

As Exhibit 2 shows, for the three-month period ending March 31, 2020, 61.2% of funds in the Australian Equity General category were outperformed by the S&P/ASX 200. This was more or less in line with the results as of Dec. 31, 2019. What becomes more interesting is when we look at the results on a month-by-month basis, we saw a steady improvement in the performance of funds in that category across the three-month period, with the number of funds outperformed by the benchmark decreasing from 78.4% to 50.8%. To put this another way, in January 2020, 21.6% of funds outperformed the benchmark, in February 2020, this increased to 41.5%, and in March 2020, it increased to 49.2%. The volatile market appears to have provided active fund managers opportunities to outperform the benchmark, although the benchmark still outperformed greater than 50% of funds.

Other fund categories were also not able to beat the benchmark in Q1 2020, with the exception of A-REITs. For the three-month period, 39.3% of A-REIT funds were outperformed by the benchmark.

While opportunities for outperformance by active fund managers may have increased in Q1 2020, most continued to underperform their relevant benchmarks. The challenge remains. How can investors, or financial advisors, select outperforming funds in advance? 2020 hindsight continues to prevail in 2020.

How Does SPIVA Assist Financial Advisors?

David Haintz of Global Adviser Alpha joined our mid-term SPIVA results webinar and provided a wealth of advice for financial advisors. David’s advice can be heard starting at minute 23:45. A couple of key takeaways from his advice include the following.

• Rather than using the terms active and passive for investing, David suggests using the terms forecasting (active investing) and non-forecasting (passive investing). He is an advocate for non-forecasting, as when put to the test, the forecasters have not been able to demonstrate an ability to pick stocks, market timings, or active managers so that they consistently outperform relevant benchmarks. SPIVA has been a key tool in supporting a non-forecasting approach.
• When adopting a non-forecasting approach to investing, David suggests advisors take a three-step approach.
  1. Understand: Gather data and understand whether options available to clients add value or subtract value. SPIVA is a great resource to aid in your understanding;
  2. Believe: Look at the available alternatives and start to believe in what will be the best possible option for your clients; and
  3. Articulate: Once an advisor understands and believes in a non-forecasting approach, the articulation of that proposition is easy, as there is so much evidence for non-forecasting that your passion for this approach will naturally flow as you talk to your clients.
• Finally, when adopting a non-forecasting approach, be aware that this does not inoculate clients from negative markets. Keep your conversations with clients focused on their goals and aspirations, rather than on returns over 1, 3, or 12 months.