It’s been over 40 years since John Bogle created the first index mutual fund. His common sense explanation that investors in aggregate will earn the return of the market minus the expenses they pay has revolutionized the industry. While low-cost index funds have exploded in popularity in recent years, actively managed funds in which managers attempt to outperform their benchmark by buying and selling stocks still dominate the market overall. This is despite the fact that the vast majority of new fund flows are entering market-based strategies such as index funds.

Active managers claim to be able to outperform markets in general despite their higher costs because they can exclude stocks they believe will underperform and own a heavier percentage of stocks they believe will outperform. They may also argue that they are better suited to navigate down markets or, that given the high valuations in the U.S. market, the environment is better suited for their strategies.

Conversely, index funds attempt to mimic index holdings and provide investors the return of that index minus fund expenses. Most index funds simply own stocks based on company size – the larger the company, the larger a percentage of the fund. This makes the process simple and inexpensive. If a company is worth 1% of the entire market, it will represent 1% of the index fund. Rather than paying the salaries of an army of analysts and increased trading costs due to high portfolio turnover, index funds are much easier and less expensive to implement than actively managed funds. So, which approach leads to better results?

Recently, the S&P Dow Jones published their annual SPIVA Scorecard comparing the results of actively managed funds to their respective benchmarks. For the first time, the Scorecard includes results going back 15 years, encompassing a full market cycle. The results are astonishingly poor for active managers across all markets.

For many asset classes, fewer than 10% of active managers were able to outperform their benchmark returns.

In addition, nearly half of the funds that were available to invest in at the start of the 15 year period even survived, with many closing or merging into more successful funds.

This begs the question, “Why do active managers so rarely accomplish their goal of beating their respective benchmark?”

The most common answer to this question is that active managers typically have much higher costs. According to Morningstar, asset-weighted expense ratios for active funds were .78% as compared to .18% for index funds. A .60% expense hurdle definitely presents an onerous hurdle for managers to clear, but there is more to the problem for active managers than simply higher costs.

As a recent study performed at Arizona State University shows, the majority of stocks fail to even outperform treasury bills over their lifetime. A very small percentage of stocks experience extreme outperformance while the majority of stocks underperform the market. As the study shows, “when stated in terms of lifetime dollar wealth creation, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing 4% of listed stocks.”

Because most stocks fail to even beat treasury bills and such a tiny percentage of stocks are responsible for the majority of the outperformance of the stock market over time, it becomes extremely difficult for an active manager to pick enough of the “high-fliers” to keep up with the broad market. For every company like Apple out there, there are thousands of companies that fail.

The only way to assure you have exposure to the tiny percentage of stocks that do experience massive outperformance is to own little pieces of everything. This is what a market-based approach does. Instead of picking and choosing individual stocks, we prefer to own them all. Yes, this means we will own a large number of stocks which fail to outperform their index; however, this also means we will have exposure to those few stock names which experience hyper-growth.

The data continues to show that low-cost, market-based approaches like index funds lead to better outcomes than actively managed strategies for a variety of reasons. However, we believe even this process can be improved upon in order to garner even better results for investors. In next month’s blog, we will explore how we may be able to structure investments to improve upon the returns of simple size-based index funds.