## Active managers outperform the index by 0.12% before fees?

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acegolfer
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### Active managers outperform the index by 0.12% before fees?

"Active managers outperform the index by 0.12% before fees"
source: http://www.nerdwallet.com/blog/investin ... ket-index/
The author admits his study has survivorship bias, which got me to thinking. What will be the scientific "empirical" results?

Note 1: I'm aware of Sharpe's arithmetics.
Note 2: This is not about a debate about whether to indexing or not. Please let's not go there.
Note 3: The original subject had "most" which is ambiguous. So I changed the subject. If this is an issue, I'll re-create a new thread and close this one.
Last edited by acegolfer on Tue Feb 24, 2015 1:29 pm, edited 3 times in total.

flyingaway
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### Re: Do most active managers outperform index before expense?

I guess they cannot. Because the index is defined at the 50%.

nobsinvestor
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### Re: Do most active managers outperform index before expense?

Simple math tells me that half of all active managers must underperform, before fees.

acegolfer
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Joined: Tue Aug 25, 2009 9:40 am

### Re: Do most active managers outperform index before expense?

nobsinvestor wrote:Simple math tells me that half of all active managers must underperform, before fees.
OP asked for empirical results not math.

Since you brought up Sharpe's math, what will happen to active manager's performance when we have amateur investors who underperform index? Shouldn't most active managers outperform the index (50%) now because of underperforming amateur investor?

anil686
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### Re: Do most active managers outperform index before expense?

While I index and think indexing is the best strategy - I do not doubt that study. Frankly, the market is made up of all participants - individual stock pickers, hedge funds, active fund managers, and market indexers, etc. - all that Mr. Bogle said in The Little Book of Common Sense Investing is that for every winner above the index, there has to be a loser of equal magnitude - that could be individual stock pickers, Berkshire stock that trailed the index in that particular year, hedge funds, or active managers...

As a whole, it is hard for me to imagine most do not beat the index before fees - even with fees included Mr. Bogle showed that 1/3 actively managed mutual funds beat the index every year - the key is not the same ones year in and year out. For persistent outperformance was based largely on expenses - those that beat the index net of fees continued to be competitive with the index because their fees were in the lowest quartile. Even after 10 years, 1/6 actively managed mutual funds beat the index inclusive of fees - the trick is knowing in advance which ones will do that which may be a fool's errand - this was explained in Mr. Bogle's Common Sense on Mutual Funds. From 1982 to 1997, the SP500 index (VG's) outpaced all but 12 actively managed mutual funds in the large cap space during that time period net of fees.

Hope that helps...

nobsinvestor
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### Re: Do most active managers outperform index before expense?

acegolfer wrote:
nobsinvestor wrote:Simple math tells me that half of all active managers must underperform, before fees.
OP asked for empirical results not math.

Since you brought up Sharpe's math, what will happen to active manager's performance when we have amateur investors who underperform index? Shouldn't most active managers outperform the index (50%) now because of underperforming amateur investor?
It's not Sharpe's math, it's basic math. The Total Market index fund will capture the average return. An average means half are higher, half are lower. So it's 50% for that reason

No to amateur investors per your theory. Most of the market activity is done by professional investors I believe something like 80%. Amateurs trading in their pajamas will not move the price of any stock. Active managers are competing with each other- other professionals.

Gropes & Ray
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### Re: Do most active managers outperform index before expense?

I believe it's possible for the average fund manager to beat the index by 0.12% because of the number of non-manager market players who can underperform by 0.12%. However, I highly doubt any fund manager can reduce fees for an active fund below 0.12% without simply becoming a closet index. Further, even if the average manager beat the index after fees, you have no way of knowing where any individual manager will fall on the spectrum from those who beat the market considerably to those who underperformed badly. Therefore, I would still choose the index to guarantee myself a certain percentile of performance (say the 49th percentile), rather than risk falling well behind.

The good news is that (in real life) the index is at about the 66th percentile after fees, each year. If you consistently perform in the 66th percentile on a yearly basis, you'll wind up well ahead of most.

anil686
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### Re: Do most active managers outperform index before expense?

nobsinvestor wrote:
acegolfer wrote:
nobsinvestor wrote:Simple math tells me that half of all active managers must underperform, before fees.
OP asked for empirical results not math.

Since you brought up Sharpe's math, what will happen to active manager's performance when we have amateur investors who underperform index? Shouldn't most active managers outperform the index (50%) now because of underperforming amateur investor?
It's not Sharpe's math, it's basic math. The Total Market index fund will capture the average return. An average means half are higher, half are lower. So it's 50% for that reason

No to amateur investors per your theory. Most of the market activity is done by professional investors I believe something like 80%. Amateurs trading in their pajamas will not move the price of any stock. Active managers are competing with each other- other professionals.
I think Bogle wrote in Enough that about 80% of the securities of the SP500 are held by mutual fund companies, retirement plans (I forgot the term he used), pension plans, and institutional investors while 20% are held by individuals. The point being made here is not moving the price of a stock, it is return on a portfolio. Mr. Bogle estimated that about half of the 80% via institutions/mutual funds were indexed leaving the other half - by definition - actively managed. If the 20% of individual investors lagged the broad market by 1%, and 40% of the participants indexed - that leaves the actively managed 40% gaining a full 1% over the market return. The reason that I took away from that chapter as to why active management cannot beat the index over time is cost. If it costs 2% (all in with transaction costs, ER, 12-b1 fees, etc.) - then active management will find it hard to compete with the index. Mr. Bogle outlines the ways an actively managed fund can compete very favorably with the index:

a) low fees
b) low portfolio turnover
c) minimize transactions and thus capital gains

WolfpackFan
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### Re: Do most active managers outperform index before expense?

I know you requested empirical evidence which unfortunately I do NOT have, but I would venture a guess that "amateur" "individual" investors represent a tiny negligible fraction of the money in the markets. If so then I would tend to agree that 50% of active managers beat the market and the other 50% take a market beat down BEFORE fees.

Additionally, I think the split between amateur individual investors winning vs losing against the index would be pretty even as well, even further negating their presence in the market as being a statistically significant factor to active managers.

I could be wrong about that but I couldn't find any stats on this from a quick google search.

LateStarter1975
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Joined: Tue Jul 02, 2013 4:50 pm

### Re: Do most active managers outperform index before expense?

Gropes & Ray wrote:I believe it's possible for the average fund manager to beat the index by 0.12% because of the number of non-manager market players who can underperform by 0.12%. However, I highly doubt any fund manager can reduce fees for an active fund below 0.12% without simply becoming a closet index. Further, even if the average manager beat the index after fees, you have no way of knowing where any individual manager will fall on the spectrum from those who beat the market considerably to those who underperformed badly. Therefore, I would still choose the index to guarantee myself a certain percentile of performance (say the 49th percentile), rather than risk falling well behind.

The good news is that (in real life) the index is at about the 66th percentile after fees, each year. If you consistently perform in the 66th percentile on a yearly basis, you'll wind up well ahead of most.
+1
Debt is dangerous...simple is beautiful

SamB
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### Re: Do most active managers outperform index before expense?

An average does not mean 50% are higher and 50% are lower. Maybe you are confusing an average with the median. What Sharpe said was that if you consider the total capital market, and you divide it up between passive (owns the total capital market and obtains the market return) and active investors, then the average return of the active investors must be the market return. You can write out the identity and then solve, or just think about it, or just admit that it is obvious, whatever. You can slice and dice the pool of active investors anyway you want to, e.g., dummies and smarties, Harvard versus Stanford MBA's, Warren Buffet versus the rest of those trading in the active pool, but the active investors, as a group, must yield the market return. If you obtain empirical evidence that says otherwise, then the empirical evidence is wrong, and you should go back to gathering your empirical evidence.

Fees are another matter, and to see what is happening relative to fees you do need to go obtain empirical evidence. Additionally, if you are interested in some subgroup within the active group then you need to gather empirical evidence to see how this subgroup fares. However, as a group the average return of the active managers is average, or the market return.

tyler_cracker
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Location: sending out the kicking team

### Re: Do most active managers outperform index before expense?

nobsinvestor wrote:An average means half are higher, half are lower. So it's 50% for that reason
that's not what "average" means.

flyingaway
Posts: 1885
Joined: Fri Jan 17, 2014 10:19 am

### Re: Do most active managers outperform index before expense?

There is a way for all active managers to beat the index. They can collude to buy only a given subset of stocks. Those stocks will outperform the market. Since the index has to hold all stocks, it will underperform.

In this sense, even if they do not collude, there is a possibility that most (or 51%) of them choose the winning stocks, and their funds will outperform.

So, my previous guess might not be correct.

acegolfer
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Joined: Tue Aug 25, 2009 9:40 am

### Re: Active managers outperform the index by 0.12% before fee

Is this logic wrong?

Suppose
1. Population consists of group A and group B.
2. average A > average B
3. Therefore, average A > population mean.

nobsinvestor
Posts: 302
Joined: Sat Jul 19, 2014 1:36 pm

### Re: Active managers outperform the index by 0.12% before fee

My bad, I was thinking of median, not mean for a second there. Thanks for correcting me. I do wonder what the median underperformance is though.

ERMD
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### Re: Do most active managers outperform index before expense?

nobsinvestor wrote: It's not Sharpe's math, it's basic math. The Total Market index fund will capture the average return. An average means half are higher, half are lower. So it's 50% for that reason
100 + 100 + 100 + 100 + 1 = 401
average = 80.2
only 1 "underperformed" the average.

this is the difference between the mean and the median.
between scotch and nothing, i'll take scotch. -- faulkner

pkcrafter
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Contact:

### Re: Do most active managers outperform index before expense?

flyingaway wrote:There is a way for all active managers to beat the index. They can collude to buy only a given subset of stocks. Those stocks will outperform the market. Since the index has to hold all stocks, it will underperform.
No, if all active managers buy only a given subset of stocks, that mix becomes the market profile. An index simply tracks the profile created by investors.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

ginmqi
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### Re: Active managers outperform the index by 0.12% before fee

acegolfer wrote:
"Active managers outperform the index by 0.12% before fees"
source: http://www.nerdwallet.com/blog/investin ... ket-index/
The author admits his study has survivorship bias, which got me to thinking.
I wish where to find an active fund that charges less than 0.12% in fees.

Also this study only looked at 10 years prior to 12/31/2012. This conveniently misses the 2000/2001 bear market. They should've looked at longer periods...20/30/40 years as well. Because most people's investment horizon falls between 10-20-30-40 years....so should look at active vs passive in 20/30/40 year blocks as well lookinG back.

"As of December 31, 2012 there was over \$7 trillion invested in over 23,000 actively managed mutual funds and ETFs, almost three times the \$2.5 trillion invested in passive funds."

This is a critical point to note. The "market" is predominantly active traders/managers. And so index is not going to be in the middle....in fact I believe indexing puts up in the 75-80% percentile because as data shows only 24% outperformed the index

And by outperforming....how much?

0.01% or 1% or 10%? Just because it outperformed doesn't mean the actual excess returns will be of any significance to the real world.

If 24% of the outperformers all returned 10% above the index....THEN there is something there to look at and maybe a system/approach may be viable

If 24% all outperformed by 0.5%.....then it's pretty laughable.

afan
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### Re: Active managers outperform the index by 0.12% before fee

There are a lot of empirical papers. Try the Fama and French "Luck vs Skill" paper. Its references include much of the good literature up to that point (a few years ago).

Trying to answer this question with a data set contaminated by survivor bias is pointless. Doing financial research correctly is hard, takes patience, and running down a lot of little details. Survivor bias is a BIG detail.

No, active managers do not beat the passive market funds before fees.
The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark-adjusted expected returns sufficient to cover their costs. If we add back the costs in fund expense ratios, there is evidence of inferior and superior performance (nonzero true α) in the extreme tails of the cross-section of mutual fund α estimates.
The Journal of Finance

Volume 65, Issue 5, pages 1915–1947, October 2010
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

ginmqi
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### Re: Active managers outperform the index by 0.12% before fee

The only thing that has convinced me what "active management" really do is only to siphon off fees from investors.

Hedge funds are known to have taken hundreds of billions of profits for management while leaving little to the investors and studies of active funds (when not contaminated by survivorship bias) show same thing percentage wise.

So it's basically a loser's game if you are the investor. Still amazing how a large majority of money is still in active funds vs passive funds. And so by default, the lower fees of the index funds provide higher returns.

acegolfer
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### Re: Active managers outperform the index by 0.12% before fee

afan,

Thanks for the FF paper. I glanced through it and found a very interesting point related to this thread.

The alphas of EW actively managed funds are positive. This means the average active managers beat the benchmark. (Don't get me wrong. I'm not saying we should invest in active funds.)

grabiner
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### Re: Do most active managers outperform index before expense?

Gropes & Ray wrote:I believe it's possible for the average fund manager to beat the index by 0.12% because of the number of non-manager market players who can underperform by 0.12%. However, I highly doubt any fund manager can reduce fees for an active fund below 0.12% without simply becoming a closet index.
Vanguard doesn't quite do it, but Vanguard does have only a 0.11% fee difference between Admiral shares of its cheapest active fund (Equity-Income) and the corresponding index (Value Index). Wellington at an extra 0.09% and Wellesley at an extra 0.08% come even closer to the costs of a blended index. If there is 0.12% of alpha, Vanguard has a chance at capturing it. Any of these three would be a fine fund for an IRA. (In a taxable account, these three funds are all tax-inefficient; you could be giving up a full 1%.)
David Grabiner

comeinvest
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### Re: Active managers outperform the index by 0.12% before fee

Hedge funds and managed futures funds (e.g. long/short, global macro, trend following) have relatively consistently provided a low single digit percent market-neutral annual return for decades after fees, if I'm not mistaken. If those funds are market-neutral, wouldn't that mean that the managers were able to consistently select stocks outperforming (long) and underperforming (short) the index?