Post: Interview with Andrew Innes on Active vs Passive Performance

Interview with Andrew Innes on Active vs Passive Performance

What Are Active and Passive Funds?

Okay Andrew, well it's a great pleasure to meet you. You're Andrew Innes, you published the European SPIVA report, so let's just say what it stands for?

So it's the S&P index versus active SPIVA scorecard.

So it's the S&P index versus active scorecard. So tell me why you create the scorecard and what an active fund is.

So the SPIVA scorecard measures the performance of actively managed funds against their respective benchmark. So a benchmark being a broad measure of performance of the equity market.

Okay so let's say I'm a fund manager and my job is to do what?

So a fund manager obviously his primary objective is to outperform a benchmark.

Okay so let's let's say my benchmark was the FTSE 100 and the FTSE 100 goes up by 10 percent in a year, what would be expected of me?

So you would be hoping to achieve returns in excess of 10 percent.

Okay but if I just tracked that 10 percent, if I just have a dumb fund which just tracks the benchmark that would be very cheap to do presumably?

Yes so there are passive index linked products in the ETF space which have typically much lower fees.

So I think for some of them you'd just pay 0.07 percent per year so if you invest a hundred pounds you just pay, I think, seven pence per year.

Yes so there is this big difference between the fees charged in the passive space and the active management space so the SPIVA scorecard is there to just highlight and find and contribute to that debate to show what the performance of these active managers is with regard their respective benchmark.

So that really adds value because there's been this massive debate about whether people can actually consistently beat the market because that's been the big question.

Yeah and that's why we show the analysis over multiple time periods starting at one year and depending on the region up to ten, fifteen years to show what proportion of funds are outperforming over those longer term horizons.

What Are Alpha and Beta?

Okay so I think some people also call this alpha don't they? It's how much you can outperform the benchmark.

Exactly, so alpha is outperformance and beta it's kind of your portfolio sensitivities to just the general market performance.

And alpha would be expensive because it requires real skill to choose the stocks which will outperform the market?

Yes that's the theory, that investor skill can lead to outperformance, and we're just providing information to help inform people in that debate.

Okay so I think the European SPIVA report has only been around for four years but it obviously looks back over a longer period because you have data which extends back in time. The U.S. one has been around for 15 years.

Yep, so we have 15 years of data in the U.S. we currently have 10 years of history for European SPIVA.

How Are Active Funds Doing Globally?

I guess the next question is how well have active funds performed globally?

Well in general if we look across all the regions and countries and just look at like recurring themes that we see in general we see that the majority of actively managed funds across any category it's always typically underperforming the benchmark whether that's over the short term or long term but when we do see a particular category that may be outperforming it's usually not seen in multiple periods so if they are outperforming for one particular time frame maybe the most recent year then we don't see that occurring over five and ten years. So the most recent SPIVA score cards for the U.S. and Europe are a good example of this because we saw some improvements in the active management performance but the longer term picture just remained unaffected we see the same high proportion of funds underperforming over five and ten years.

Short-Term Outperformance Much Easier Than Long-Term 

So quite disappointing globally, but you do have pockets, you do have variation across different regions don't you?

Yeah exactly, so over the short term it may be relatively easy to outperform given say a risk on environment so maybe size, small cap stocks have outperformed so any funds that are exposed to that small size, with less exposure to larger cap companies and they found it easy to outperform.

Okay so let's just unwrap that a little bit so during one of these market rallies when everybody's buying stocks, some people have described it as Animal Spirits abounding. So lots of people are willing to take risk and they buy stocks and the stock markets rally so things which are more risky tend to perform well in that environment like small cap stocks.

Exactly. Little companies. So in particular in the UK we do see this correlation when risk-on and size is doing well we see the actively managed funds in the UK also performing very well but again it's just a short-term thing that we see, we don't see it persistently outperforming. So it's very difficult to time your exposure and allocations to these particular styles that are doing well in the short term. It's very difficult to do the same over longer time periods, so it's difficult to allocate correctly.

Now let's just play devil's advocate for a minute, so let's say that there was a fund manager which just randomly allocated or just took one of these styles and ran with it. They may perform well during one certain period like you were saying but over the long term like a whole business cycle which is usually about a decade they wouldn't perform well or consistently, that's what you're saying?

Well we're not saying it's the same, when we look at all funds combined together you see the majority of funds don't do well, but whether certain funds can do that well that's obviously possible but we're looking the bigger picture.

Okay so for an investor I think the difficulty is finding the funds that outperform so do you have any advice for how to choose funds which are going to outperform in the future given the results of your scorecard?

No that's not something that we would provide information on, we're just trying to show you the numbers, to let market participants use those to help justify whether or not actively managed fees are worth the cost that they pay, and we just let the numbers do the talking.

Is Alpha Easier To Find In Inefficient Markets?

One of the things in the U.S. is that it's very efficient market. In other words the market instantly prices in any new available information whereas markets which are less efficient in theory should be better for stock pickers. Could you talk a little bit about that and why it might be the case?

Yes so the theory is in these smaller markets where there's less volume stocks may not be priced at their fair value so there may be more opportunity to outperform so information, analysis could actually give investors an edge, but as a theory we're not able to conclusively prove whether that's the case or not with the SPIVA Scorecard because we kind of see mixed messages. For instance in the UK as I mentioned that category in general does particularly well compared to others.

The small cap one?

Yeah the small cap, and we believe that maybe because of this less efficient market theory that there's a larger opportunity set, more scope for discovery but in contrast when we look at the emerging market equity funds, again in the Europe SPIVA scorecard we see that that's actually one of the worst performing categories and it has consistently been one of the worst performing categories. Whereas if you believe that less efficient markets lead to extra alpha then you would expect that category to do well and we're just not seeing that.

Okay so it doesn't really seem to be panning out that less efficient markets are doing so well.

Yes, the message is definitely mixed.

Okay so some people have said that a fairer comparison for S&P to do would be to compare active funds versus passive funds. So let's say we had a stock picker for the FTSE 100 they would be compared versus the trackers for the FTSE 100 because that would also include the fees that you get for the average FTSE tracker. Would that be a more fair comparison and why don't you do that?

I understand the point, the issue is that obviously we're an index calculation engine and the fees that are charged on these passive ETFs are entirely down to that ETF provider so we're not responsible for that and we can't advocate certain funds of passive funds over others so we just wish to show the active manager performance with respect to their benchmark because ultimately that gives investors enough information if those active funds are trying to outperform the benchmark we're just providing that information.

So that's their job, right, to beat the benchmark and so you're neutral on, you want to remain neutral?

And also as we've already said said fees that are charged on passive ETF products are obviously typically much lower.

Do Longer Investment Horizons Improve Performance?

Okay so if I wanted to tell whether it was skill or luck which made people outperform now I'd be willing to pay for skill I wouldn't be willing to pay extra to an active fund manager if they're just lucky. But if I want to discriminate between those two presumably I'd look over a longer horizon, so I'd look over one year that would be fairly volatile, then I'd look over two years, five years, maybe even ten years to see which managers are the best. So could you talk a little bit about what it looks like, your results, when you look over a longer horizon?

Yes I can quote some figures from the recent SPIVA Survey, we had results in mid 2017. So in Europe so pan-European equities actively managed funds we saw around fifty one percent underperformed. So that was a particularly good year for active managers.

And that's in a single year?

Yes this is the most recent year. So it's 50/50? Yeah pretty much 50/50 and still that's one of the better performing years. But when we go to a ten-year horizon the number increases to 87 percent. Sorry 87 percent of the funds are underperforming their benchmark or in other words not doing what they're paid to do. And the same picture is true in the U.S., again a relatively good year only fifty six percent of funds underperformed over a one year period.

So worse than the UK?

That's U.S. large cap. Yes, slightly worse than the UK. And that figure increases to 85 percent over 10 years.

That's pretty shocking isn't it? Only 15% of the people that actively managed funds outperform the benchmark.


Over the long-term... so that kind of suggests that it's luck rather than skill which is driving the performance?

Well it's not our position to say, we'd let others make that decision.

Luck or Skill: The Persistence Scorecard

It is consistent with that. So one of the great things that you have in the U.S. is, as well as the SPIVA which measures performance of funds versus the benchmark, the percentage that outperform over different horizons, you also have this Persistence Scorecard. So why do you need that in the U.S. and what does it tell you that SPIVA doesn't?

Yeah the Persistence Scorecard as you say is available in the U.S. and that's really trying to show the consistency of out- performance in consecutive periods.

So this is the luck versus skill.

Yeah it's trying to really differentiate between luck versus investor skill. So if there is real investor the skill then they should be able to prove that they can be in that group of top performance persistently from one period to the next. So what we'll do is categorize all those funds in the top quartile and then say what proportion of those are also in the top quartile the next period, and so on. And we see in the US that obviously relatively few funds can remain in that top performing quartile for multiple periods.

People I've seen have said that that's because it's a very efficient market it's hugely over-analyzed if you like so it's so efficient it's hard to beat the index, do you think that's a fair criticism?

Yeah it's absolutely fair. The size of the U.S. mutual fund market's massive isn't it, I think it's over ten trillion dollars, the mutual fund industry in the U.S.? Yeah it's a very large market and obviously there are passive index-linked ETF products that will provide exposure to that market without the typically high active management fees associated with them as well.

So for example Vanguard they track the S&P 500 for 0.07% per year, yeah okay, so it's very difficult to compete with that, as Warren Buffett has pointed out recently.

Yeah absolutely.

Survivorship Bias Matters

One of the problems with tracking performance over time is survivorship bias. Could you just quickly explain what that is?

Yes so during a period of analysis there may be several funds which liquidate or merge and those funds are not there at the end of the study so if you're only calculating the performance for funds that survive at the end of the period then you would actually be artificially inflating, because the funds that liquidated are typically poor performers so by not including those poor performing funds that don't survive to the end of the period it might look like the performance of active managers is actually greater than it is. So what we do with the SPIVA Scorecard is actually include the entire opportunity set as of the beginning of the period to include all those funds whether or not they survived to the end.

So it would artificially inflate the performance.

So if a fund liquidates or merges at some point well it's still including their performance from the start of that period.

Okay so if I buy an active fund one of the problems is that it may not survive because if it underperforms they often liquidate the fund, so could you just give us a feeling for the survivorship for funds in the UK?

Yeah absolutely so we saw that over the one-year time horizon in the last Europe SPIVA Scorecard for the UK for instance by category saw that in one year ninety five percent of funds would survive for that whole period. So of the funds that would be available beginning only ninety five percent are there at the end. But then when we look at ten year we see that only forty five percent of funds that were actually in existence ten years ago were still, have survived now.

So a lot of these funds, over a 10 year period more than half of them just liquidate.

Yes, one could only assume that's due to poor performance.

Okay that is pretty shocking as well. Okay so it's very difficult if you're an active investor if you buy active funds to firstly find a fund that you think will outperform, given persistence is low over time but also because survivorship is fairly low over a decade. So you may end up with a fund that no longer exists and you have to re-allocate your capital.

Yeah the figures do show that it would be very difficult over a long time horizon to choose a fund which survives the entire period about outperforms over that period too.

Okay well that's been really interesting, thank you so much for your time and thank you to S&P also for producing this really valuable report. Thank you Andrew.