The evidence shows that over the long term, active management rarely outperforms its benchmark . The renowned SPIVA research , updated annually by S&P, measures the performance of actively managed funds against their benchmark. As can be seen in the table below for US equity funds, the percentage of funds that consistently outperform their benchmark is very low, especially over long horizons (for example for the S&P 500, 94% fail to do so, i.e. only 6% outperform over 20 years).
Why doesn't active management beat the index?
One might wonder why active management fails to outperform the benchmark in most cases, despite the vast resources and skills available to active fund managers.
As we have pointed out many times, one of the reasons is cost .
Active management is more expensive than index management. Therefore, costs chinese overseas british database have a large impact on long-term investment performance.
There is another lesser-known and somewhat more technical aspect that we focus on in this article, and which also goes against active management: the returns of the individual components of an index, i.e. the stocks that comprise it, tend to be positively skewed .
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What does it mean?
This means that a limited number of stocks achieve high returns (the right end of the distribution), while most stocks fall below the average.
Statistically speaking, in a right-skewed distribution, the average return is greater than the median return (the value that divides the top 50% of observations and the bottom 50%).
So when a manager selects a stock, he has a 50% chance of getting a return above the average return. But he has less than a 50% chance of getting a return above the average.
Since active managers typically select a small number of stocks, the probability of picking the ones that outperform the average is not 50/50, but rather smaller.
Since the number of stocks below the average return is greater than the number of stocks above the average.
We can see all this in the following graph:
Constituent results SP500 of index management
Why does index management put luck on your side?
It would be reasonable to think that the skills of active managers would allow them to select some of the few stocks that do extremely well. But there is clear evidence that the returns from active management documented by SPIVA and other reports do not support this thesis.
Investing in individual stocks rather than the average of stocks, which is what index investing does, turns the law of probability against the active manager .
It is a fact that the returns of active funds do not seem to demonstrate that the skills of the managers can overcome this.
When a limited number of stocks account for most of the index's returns, a concentrated portfolio is less likely to own the big winners .
There is very little chance that, thanks to any particular skill, the active manager will be able to pick exactly those stocks that do extremely well.
That is why at inbestMe we only use ETFs and index funds, as these offer a cost advantage over active funds and tend to achieve better long-term performance, also due to the fact that index returns inherit this positive bias .
That's why investing in the entire index, or indexing, puts the odds in your favor .