5.2 Evidence regarding excess returns


As discussed in Article 5.1, both the philosophy of mindfulness and the science of biases indicate that there are many ways our investing decisions (or any decisions) can go awry.  As the complexity of the endeavor increases, so too increases the number of ways our innate behaviors can mislead us.  Trying to beat the market (so-called active investing) is definitely a more complex exercise than simply trying to keep pace with it (so-called passive investing).  At the risk of overkill, this article presents some additional statistics, beyond those presented in Articles 3 and 4.1, supporting the difficulty of beating the market for all the reasons described in Article 5.1.

Professional investors

S&P Dow Jones Indices publishes SPIVA (S&P Indices Versus Active) scorecards for professional money managers.  Over a 10-year period ending in 2015, the most recent SPIVA scorecard provides the following percentages of stock fund managers underperforming the most relevant indices:

  • 82% of large-cap managers
  • 88% of mid-cap managers
  • 88% of small-cap managers

Vanguard presented a 2015 research paper containing numerous statistics on active fund underperformance including the graph shown below.  The dark blue portion of the bars include currently operating funds, while the light blue includes both operating funds and funds that closed during the period of analysis, often due to poor performance.

Vang Fund Underperformance bar chart

(The closings and mergers of funds is one complicating factor in fairly evaluating fund performance, and failing to evaluate closed funds can artificially enhance the success rate for active funds.)  While the SPIVA scorecard is confined to stock funds, the Vanguard graph shows that active fund underperformance is epidemic in stock and bond funds, both foreign and domestic.

Another way to examine active fund management is to compare the returns of actively and passively managed funds as shown in this graph.


This study evaluated the 10 years ending in 2012.  Actively managed funds had returns more often in the 0 to 5% range, while passive funds were more likely to provide returns in the 5 to 10% range.  Notably, this study did not include funds that closed during the period studied, which means the actual aggregate returns for all active funds were likely even worse than shown in the graph.

Active funds have not performed well in the past, but is it possible they are improving?  Recent commentary about active fund performance suggests the opposite is happening; active funds are getting worse at beating the market.  Here is a graph from one analysis  that focuses on hedge fund excess return (or alpha) from 1996 through 2013.

Perspective 10 14 fig 6

Given some of the statistics on hedge funds presented in Article 3, the above graph showing that hedge funds once achieved around 8% in excess returns is somewhat suspect in my mind.  Regardless, even accepting that hedge funds once beat the market, the clear trend over time is toward underperformance.  And recall that hedge funds attract the top talent because of their high cost structure.

But perhaps these comparisons are too broad.  Could there be a subset of active fund managers who outperform the market consistently?  Maybe we could just select that subset of funds to create a beat-the-market portfolio.  S&P Dow Jones Indices also publishes a “persistence scorecard”, which examines whether picking funds based on past performance, presumably because some managers are more skillful than most, would provide a better outcome for individual investors.

In the most recent 2015 persistence study, S&P Dow Jones started with 2,862 actively managed domestic stock mutual funds that were in operation for the 12 months through 2010.  They then examined the past performance of these funds and selected the top 25 percent (top quartile) of funds with the best returns over those 12 months.  They then identified how many of those funds actually remained in the top quartile in each of the four succeeding 12-month periods through March 2014.  The answer is that only two of the actively managed funds were able to stay in that top quartile.  This number is remarkably low given that just through luck we would expect several of these funds to stay in the top quartile for a period of five years.

The very best investors

What if we took it one step further? Surely there are a few exceptional professional investors who usually beat the market, allowing for a bad year now and then.  Good information on exceptional investors is a little hard to find, because so few investors seem to beat the market.  So, let’s look at the often cited best investor of recent times, Warren Buffett.  He is famous for beating the market by purchasing stocks of a few well-managed companies, particularly at times when these companies were undervalued by the market.

Here is a graph of the out-performance (excess returns) of Warren Buffett’s company, Berkshire Hathaway, as compared to the S&P 500.

Buffett performance graph

Clearly, Berkshire Hathaway has an outstanding record as compared to most of the professional investors we have examined.  The company has 22% compound annual returns (including dividends) since 1965, while the S&P 500 had only a 10% annual return in that same period.  But even here we notice that the heydays of stellar excess returns are over.  Since 1996, Berkshire Hathaway excess return had an annual average of about 2.3%.  As I have discussed previously, random chance predicts that out of thousands of brilliant active investors at least a few should beat the market over the long hall just based on luck.  I am not saying that Warren Buffett is all luck, given there is considerable other evidence available that his investing methods contributed to this success.  But I think it’s reasonable to say that his success is at least a combination of well applied methods, some luck, and later in his career, the advantages of being a big player.

Regardless, our mindful humility advises that it is unwise for individual investors to try to copy the best known professional investor, who expends almost all his time, energy, and obvious intelligence to this single endeavor.  If we humbly submit the question to the guru himself, Warren Buffett has provided crystal clear advice for us individual investors.  For example, he has publicly stated he advises his wife to, after his demise, buy a stock index fund with 90% of their assets and simply hold it.  He has given essentially the same advice for all individual investors and noted that hiring someone to manage your money is essentially uselessIt’s hard to argue with him.

Individual investors

If professional investors have a hard time beating the market, you’ve probably guessed by now that the news is worse for small individual investors like us.  Here is a graph of returns by asset class from JP Morgan with the average investor returns added.  If individual investors can’t seem to routinely perform even as well as holding a 100% bonds, then in aggregate, there are very little excess returns happening for individual investors, although individual outliers assuredly occur.  

Investor behavior – The reason for this under performance are emotions, as detailed in Article 4.1.  Individual investors jump in and out of investments due to emotional decisions (like panic selling) and the innate biases discussed in Article 5.1.  This behavior is illustrated by a graph from a 2011 study by Philip Maymin and Gregg Fisher.

Stock inflow and outflows

The excess net inflow or outflow of money into bond funds over equity funds (in light red) shows that, as the stock market goes down, many investors are pulling money out of stocks, and into the perceived safe haven of bonds, and they are putting money back into stocks as the stock market goes back up.  This behavior results in many investors missing multiple days of positive stock fund performance.  Many of the biggest up days in the stock market happen after a long-term bottom is achieved as the blue line for the S&P 500 shows in the above graph.  In his bookWinning the Loser’s Game”,  Charles Ellis notes the following decrease in average annual compound returns for the S&P 500 during a 28 year period when a few big days are missed:

  • S&P 500 – 11.1% return
  • S&P 500, but missing the 10 biggest days – 8.6%
  • Missing the 20 biggest days – 6.9%
  • Missing the 30 biggest days – 5.5%

Approximately half the average annual return of the S&P 500 in this 28 years can be attributed to just 30 days.  So, seemingly trivial decisions like being out of the market for a few days, can end up having a huge impact on your investment success.

Individual investor gaps – Other research verifies the poor performance of individual investors.  Looking at investments in specific funds, several studies have shown that individual investors achieve returns that are 1 to 3 percent lower than the funds themselves.  This percent “gap” between the investor and fund performance over time is summarized in this graph from the Maymin and Fisher study as a “behavioral trading cost”.

Behaivoral cost gap

And Morningstar reported that these behavioral trading gaps apply regardless of the type of funds involved, as shown in this table.

Table of cost gaps

Chasing performance – The opposite of the panic selling discussed in Article 4.1 is called “chasing performance”.  As we noted above, there is little evidence that fund managers who perform well for several years will continue that good performance into the future.  So, selecting funds based on past performance is unlikely to be fruitful.  Individual investors seek the “hot hand” only to find the luck has gone cold once they get in the game.  This behavior leads to lower individual investor returns as compared to simply staying in the same fund over the same period as shown in this graph from a Vanguard study.

Bar graph buy hold vs performance chasing

More importantly, because many actively managed funds fail to beat index funds, when individual investors put their money in active funds they often get the double whammy of poor performance from both the fund and their own emotional investor behavior.  This dual poor performance mostly explains why the aggregate returns for individual investors (as shown in the JP Morgan graph above) is so far below the returns for most investment asset classes.

All this underscores the question, why do people invest in active funds at all?  The next article (Article 5.3) reviews some of the ongoing debate between so called “passive” versus “active” investing.