The nineteenth-century feud between the Hatfields and the McCoys doesn’t hold a candle to the debate between supporters of index funds and supporters of active management.
Those in the index fund camp cite decades of data—going back to the 1930s—to support their view that active management is a fool’s errand. Each year, in fact, Standard & Poor’s publishes a study it calls SPIVA—S&P Index Versus Active. And each time, they reach the same conclusion: that it’s exceedingly difficult for an actively-managed fund to beat its benchmark. As an example, on SPIVA’s website today, it states that 75% of large-cap funds have underperformed the S&P 500 over the past five years. In other words, you would’ve been better off flipping a coin than investing with an active manager.
Largely because of this data, actively-managed funds have been losing ground to their index fund competitors. But still—despite the data—many investors aren’t convinced. And it’s not just a fringe element. The active management business is still enormous, with trillions of dollars under management. Why is that the case? Is it possible that so many investors are unaware of the long odds against them? That may be true in some cases, but that’s not the whole story. There are actually quite a few reasons why people still support active management. Even if you remain on the index side of the fence—like me—I think it’s useful to understand why others might see it differently. Below are seven common arguments:
- Probabilities: Yes, the odds are long. But many investors who choose actively-managed funds understand that there’s a difference between low probability and zero probability. Even if the SPIVA numbers say that 75% of funds underperform their benchmarks, that still means that 25%—one out of four—outperform. Put that way, it doesn’t seem as crazy to seek out a fund with high potential. And further, that 75% figure isn’t uniform across all fund categories. There are several categories in which the odds are much better. In fact, a majority of actively-managed funds have outperformed in some categories over the most recent five-year period. Also, that 75% doesn’t apply to every time period. It varies considerably from year to year. I still don’t invest in active funds, but through these lenses, you can see why someone might choose to make that wager.
- Economic environment: Index funds are designed to track the market. That’s great—until the market drops. For that reason, many believe that active management pays off during bear markets. The logic here makes sense. When the market drops, index funds simply drop in lockstep. But an active manager has the opportunity to take corrective action. That’s because most crises build slowly. Even when the market has dropped 50%—as it has done several times—it’s never happened overnight. Thus, active managers have a window to respond before a crisis gets worse. Logical as this sounds, though, the data doesn’t back it up. Active funds have underperformed during many stock market downturns, including 2008 and 2020.
- Risk: Some investors see risks in the structure of index funds. Notably, Michael Burry, famous for predicting the 2008 mortgage bond crash, believes that index funds are also like a ticking time bomb. That’s because they buy mostly the same stocks. He makes the analogy to a crowded movie theater, with this ominous warning: “The theater keeps getting more crowded, but the exit door is the same as it always was.” He adds, “The longer it goes on, the worse the crash will be.” Is Burry right? That’s the tricky thing. No one can say. It was only two years ago that index funds surpassed actively-managed funds in total assets. So we are in uncharted territory, and he might end up being right. I happen to disagree, but no one can say with certainty that something that hasn’t happened before won’t happen in the future.
- Mean reversion: In the investment world, it’s common to talk about reversion to the mean. The idea is that things that are far above or below average won’t stay that way forever. It’s possible this could occur with mutual funds. No one can say for sure what might make active funds shake off their slumber, but I’ve heard a handful of theories. The one that makes the most sense is the idea that active managers are more nimble and could gain an advantage as more dollars go into index funds, which just passively mimic the market. Again, this is an open question.
- Personality: When Gallup asks Americans what they think of Congress, approval ratings generally fall in the 30% range—not very good. But ask Americans what they think about their own representative, and a majority approve. It’s the same, I think, with mutual fund managers. Sure, the SPIVA numbers might say that actively-managed funds underperform on average. But when investors search for actively-managed funds, they’re not looking for just average. They’re looking for stars—and they believe they can identify them. If a fund manager has a strong track record, that helps. And if the fund manager has a strong personality, that helps even more. In this way, active funds have an edge. While index funds are largely driven by computers, active funds have public faces. And some become quite well known, bordering on cults of personality. In the 1980s, it was Peter Lynch, who ran Fidelity’s Magellan Fund with amazing success and authored several books. In the 1990s it was Bill Miller, whose fund once beat the market for 15 straight years. Today’s biggest star may be Will Danoff, the longtime manager of Fidelity’s Contrafund. When investors put money into these funds, they’re betting on the fund manager’s brilliance. The SPIVA numbers, I suspect, aren’t even a consideration.
- Yardstick: One of the criticisms of the SPIVA numbers is that Standard & Poor’s has an inherent bias. They earn millions licensing their indexes—the S&P 500, for example—to index fund companies. Because of that perceived bias, some have criticized the methodology S&P uses in its SPIVA studies. I don’t find these criticisms compelling, but it’s important to note that when S&P compiles its data, it does have an interest in the outcome.
- Priorities: As I often say, there are two answers to every question in personal finance: There’s the quantitative answer, and there’s the “how do you feel about it” answer. If you look only at the numbers, index funds definitely score well. But for some investors, that isn’t the most important thing. As I noted a few weeks ago, in fact, direct indexing has been growing in popularity. A large part of that, I think, is driven by investors who want the advantages of an index fund but hate the idea that indexes like the S&P 500 include tobacco and other distasteful kinds of companies. That’s another reason an investor might choose to go with active management.
When I was a kid, there was an exhibit at the local science museum. It was a model of a giant housefly—maybe two feet high. Attached to the exhibit was an explanation that a fly of this size would be physically impossible. I always found that interesting—that things don’t necessarily scale linearly. Something that might work when it’s small might collapse under its own weight if it got larger. I’m still very much in the index fund camp, and so far I think they’re the best investment for most investors most of the time. But I always remember that exhibit. It’s a reminder to always keep an open mind, because things can change.