Active investors had an awful year in 2021 as the market surged. What they consistently do wrong

Published Wed, Mar 16 20227:09 AM EDT

Stock pickers continue to underperform, and it isn't getting any better. The S & P Dow Jones Indices annual SPIVA survey on the performance of active mutual fund managers indicates that 79% of these managers underperformed their benchmarks last year. Longer term, the performance is just as bad: Of the funds that have been around 10 years, 86% underperform their benchmarks. In some categories, stock pickers got slaughtered against their passive benchmarks. Last year was great for growth stocks, as tech was a huge outperformer. The S & P 500 Growth index was up about 33%, but 98% of all growth fund managers failed to outperform that benchmark. It was, according to the report, "the worst performing of any U.S. equities category in the past 21 years." Many stock pickers claim they outperform when their picks are adjusted for risk, but even this is not true. Among domestic equity funds, 90% underperformed the S & P Composite 1500 over the past 20 years, but an even greater 95% did so on a risk-adjusted basis, according to the report. Some bond funds performed slightly better on an annual basis, but again long-term results were poor: More than 60% of bond funds did not surpass their benchmarks across all fixed income categories over the 15-year horizon. These figures are adjusted to include fees and adjust for "survivorship bias." About 5% of funds are merged or liquidated each year. Roughly 70% of funds go out of business after 20 years, usually due to poor performance. Stock pickers do not shine in volatile markets Stock pickers typically say that it may be difficult to outperform in a steadily rising market (everyone is a winner), but volatile markets are where they will shine. It's not true. In 2020 – one of the most volatile years in decades – 60% of large cap managers underperformed their benchmarks. "It's a slightly less bad advantage for active managers when the market is more volatile, but it's still bad," said Craig Lazzara, managing director of core product management , S & P Dow Jones Indices. Princeton Economics Professor Burton Malkiel, author of the investment classic "A Random Walk Down Wall Street," has heard these arguments for decades. "Every year we hear that while indexing worked in the past, 'Now we are in a stock picker's market,'" he said in an email. "And every year when the SPIVA results come in we learn that the majority of active investors underperform the market." Why do stock pickers consistently underperform? Academics have known for decades that active stock pickers underperform. There are many reasons: They trade too much. This increases the chances they will make investing mistakes. They charge too much. The high fees eat into the overall return, even if their stock picking skills are strong. They exhibit overconfidence in their ability to pick winners. Market timing is almost impossible to get right consistently . That's partly because you must be correct going into and out of the trade. The competition is tough and getting tougher. Larry Swedroe, chief research officer for Buckingham Strategic Wealth and the author of numerous investment books, told me, "Active funds fail miserably because the market, while not perfectly efficient, is highly efficient due to the incredible amount of highly skilled managers that are each seeking to outperform, resulting in the collective wisdom of the market being a very tough competitor. They fail not because they are dumb, but because the competition is too tough." The mathematics are against active stock picking . "Returns are driven by a relatively small number of stocks, so the median stock in the S & P 500 typically underperforms the index average," Lazzara told me. In 2021, for example, only 45% of the S & P 500 outperformed the index. "That implies that you have to consistently pick stocks that are in the upper 40% or so, and that is surprisingly hard to do." The 'hot hands' manager doesn't last Still, some fund managers do hit on streaks where they outperform, some for several years. Why not just stick with those managers? "The idea that the past predicts the future may be true in many parts of life, but not in stock picking," Lazzara told me. "You may find a manager that outperforms for a year or two, but the likelihood of outperforming long-term is no better than a coin flip." Malkiel concurs. "The managers who do beat the market in one year are often the poorest performers in the next," he told me. Lazzara's message: The rare "hot hands" manager does not last long. Even the small percentage that outperform over more than a few years aren't doing better than sheer dumb luck. "The persistence of fund performance was worse than would be expected from luck," S & P concluded in its 2019 study. What does it all mean? For Malkiel, who has studied active versus passive (index) investing for decades, the lessons are clear. "High costs, too much trading, an inability to know both when to get in and out, and the importance of unknowable and random events combine to make low-cost indexing an above average investment strategy," he told me. For Lazzara, the lesson is to be very careful when choosing an active manager. "We have been running SPIVA for 21 years," Lazzara told me. "In only three of those 21 years have the majority of active managers outperformed. An investor who chooses to use active management should realize the odds are against you. If you choose active management, make sure you get the lowest cost you can get."

A specialist trader works inside his post on the floor of the New York Stock Exchange (NYSE) in New York City, March 10, 2022.

Brendan McDermid | Reuters

Stock pickers continue to underperform, and it isn't getting any better.

The S&P Dow Jones Indices annual SPIVA survey on the performance of active mutual fund managers indicates that 79% of these managers underperformed their benchmarks last year.