Active Managers in Inefficient Markets

By Joseph Tenaglia, CFA

One of the most anticipated reports in the asset management industry is S&P Dow Jones’ SPIVA® U.S. Scorecard, a semiannual report that provides a glimpse at the performance of active managers in each asset class. The report acts as a regular checkup on fund managers and has added fuel to the active versus passive debate.

While recent years’ reports have generally acted as an indictment of active management, 2017 was more forgiving. Nearly 37% of actively managed U.S. large-cap funds outperformed the S&P 500 last year—the best showing since 2013—spurring conversation about a potential revival of active management. With the start of the financial crisis nearly a full decade ago, we thought it would make sense to dig into the report’s 10-year numbers to get a comprehensive picture of the state of the active universe.

Related: The Case for Active Management in REITs

Beta in Efficient Markets, Active Elsewhere

A common portfolio construction approach we hear from investors is that they will build portfolios using low-cost index-tracking strategies in perceived efficient markets while allocating to active managers in less-efficient markets. The rationale is that while it is tough to beat the market where information is well-known, active management should do well where alpha is seemingly more readily available.

Looking at U.S. large caps over the last decade, this thesis had merit: It was very difficult for active managers to beat the market, with only 10.49% of large-cap funds outperforming the S&P 500 over the last 10 years. However, contrary to what investors might expect, active funds in mid- and small caps fared even worse than their large-cap counterparts.

Do Active Managers Outperform in Inefficient Markets 1

Inefficiency Does Not Imply Outperformance

Perhaps the most surprising finding in the latest SPIVA report is that a greater proportion of U.S. large-cap funds outperformed their benchmarks over the last 10 years than those in the mid- and small-cap spaces.

Both broadly speaking and across all U.S. equity investment styles, large-cap funds fared the best compared to their benchmarks, with higher hit rates in value, core and growth than mid- and small-cap funds. Further, this lack of mid- and small-cap fund outperformance was not limited to the latest decade—large-cap funds also had the best relative performance over the latest 3-, 5- and 15-year time frames as well.

Contrary to common perception, the ability to outperform in the supposedly less efficient mid- and small-cap spaces was achieved by fewer than one out of every 20 managers over the last decade. If alpha was available to active managers in these asset classes, it was apparently very difficult to find.

Active Fared Slightly Better Internationally

In addition to U.S. mid- and small caps, we often hear investors leaning toward active in other specialized asset classes such as international small caps, emerging markets (EM), and high yield. While that belief is perhaps misguided in high yield—with a shocking less than 2% of high-yield funds outperforming their benchmarks—funds in international small caps and EM fared slightly better than those in U.S. equities. But not by much.