Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

S&P Dow Jones Indices recently released its biannual SPIVA Scorecard, which compares active and passive investments. I suspect few investors noticed and even fewer cared.

Investors have long accepted what the scorecard unfailingly shows -- that the vast majority of active fund managers lose to their benchmarks net of fees. The latest scorecard doesn’t alter that conclusion. Only 15 percent of U.S. equity funds and 9 percent of international ones beat their benchmarks over the last 15 years through June. The numbers are similar for fixed-income managers.

Good Luck
According to the S&P Indices Versus Active (SPIVA) scorecard, the odds of picking a market-beating active manager are low
Source: S&P Dow Jones

Given those long odds, investors are increasingly giving up on active managers and turning to index funds. But one money manager thinks it’s easier to identify market-beating funds than the SPIVA numbers suggest.

Capital Group, the parent of American Funds, a family of actively managed funds, contends the trick is to look for active funds with “low expenses and high manager ownership.” Capital Group tracks the performance of an equal-weighted portfolio of “Select Equity” funds that it chooses based on those two criteria and reports the results in its “Select Investment Scorecard.”

According to Capital Group’s most recent scorecard, the U.S. large-cap Select Equity group beat the S&P 500 Index 86 percent of the time over rolling 10-year periods from 1997 to 2016, while the international group beat the MSCI ACWI ex USA Index 87 percent of the time.

Unhelpfully, Capital Group doesn’t disclose the members of its Select Equity portfolio, though it proudly trumpets the names of American Funds that make the cut.   

All of this raises the obvious question: Are investors more likely to spot market-beating managers using Capital Group’s approach?    

I decided to give it a shot, sticking as closely as possible to Capital Group’s methodology. I looked at the universe of institutional and advisory share class actively managed U.S. large-cap stock open-end mutual funds. I included funds 1) with a net expense ratio less than 0.75 percent, and 2) in which at least one fund manager had invested a minimum of $1 million. I ended up with 93 funds.

I then compared the annualized returns of each fund with the S&P 500 Index, the S&P 500 Growth Index or the S&P 500 Value Index, as appropriate to account for each fund’s style. I found that 38 percent of the funds beat the benchmark over three years through September, 35 percent beat over five years, 50 percent beat over 10 years, and 58 percent beat over 15 years.  

I did the same thing with foreign large-cap stock funds, except that I included funds with a net expense ratio below 0.83 percent and compared them with the MSCI World ex USA Index, the MSCI World ex USA Growth Index or the MSCI World ex USA Value Index, as appropriate. This time I ended up with 13 funds. 

I found that 77 percent of those foreign funds beat the benchmark over three years through September, 64 percent beat over five years, 56 percent beat over 10 years, and all of them beat over 15 years.

Picking Winners
Actively managed mutual funds with lower fees and high manager ownership have beaten their benchmarks in greater numbers
Sources: Morningstar, author's calculations
Note: Fund universe includes institutional and advisory share class open-end mutual funds.

Those results reinforce Capital Group’s argument that choosing funds with low fees and high manager ownership meaningfully increases the odds of picking winners, particularly for long-term investors. But which of the two criteria contribute most to the improved odds?

To find out, I ran the numbers again using only fees as a criterion and ignoring manager ownership. I found that low fees explained 85 percent to 90 percent of the improved odds of choosing a market-beating U.S. fund, and more than 90 percent of the improvement among foreign funds.

It would be hasty, however, to declare iron-clad conclusions based on my or Capital Group’s findings. I looked only at the period through September, and Capital Group’s numbers include only two non-overlapping 10-year periods.

Also, Capital Group uses only the broad market as a benchmark. I broadened my benchmarks to include value and growth styles. But there are other active styles -- such as quality, momentum and low volatility -- and many combinations of them. There are also a growing number of factor, or smart beta, indexes that replicate those styles and combinations, allowing investors to more precisely grade active managers.  

This is where the SPIVA Scorecard can be more illuminating. It should report gross as well as net results so that readers can judge to what extent fees are contributing to managers’ underperformance. It should also expand its benchmarks to include factor indexes that more accurately capture managers’ active styles.   

Active management is evolving. It’s time for SPIVA to evolve, too.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in New York at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net