Let’s take a look at failure in the investing world, because we all fail. Warren Buffett, the Oracle of Omaha, makes investing mistakes. The question is: Why? So let’s take a look at some intriguing data.
The newest SPIVA Scorecard from S&P with respect to actively managed U.S. funds shows that over the 15-year period ending December 2016, 92.15% of large-cap, 95.4% of mid-cap and 93.21% of small-cap managers trailed their respective benchmarks.
Markets in every sector, every asset class and every geographical location provide similar results. Institutional managers fare no better. It is a matter of simple arithmetic and a demonstrable fact. Investing successfully is really hard.
The problem relates to skewness, the asymmetry of the distribution of returns. In any given year, the best-performing stocks skew the overall averages upward such that most stocks lag the market averages.
Some recent and powerful academic research has put a finer point on things. Using 90 years of performance (through 2015), 58% of all stocks underperformed one-month U.S. Treasury bills, while a majority lost money over their lifetimes. The best performing 86 stocks accounted for over half the $32 trillion (with a “t”) in value generated by stocks in excess of bills over that time span. Just 4% of stocks accounted for all the outperformance of stocks over bills. Active investors are not quite looking for a needle in a haystack, but their challenge is a daunting one.
A similar asymmetry applies to when stocks perform. Michael Batnick of Ritholtz Wealth Management has shown that nothing happens in the market a lot of the time, at least in the aggregate. The real growth of a dollar invested in the S&P 500 was $1.08 from 1929-’43, $10.83 from 1944-’64, $0.94 from 1965-’81, $11.90 from 1982-’99 and $1.35 from 2000 to today.
However, the volatility we suffer is surprisingly consistent. Research done by Ben Carlson, also with Ritholtz, shows the worst peak-to-trough drawdowns on the S&P 500 by calendar year through 2016. The average drawdown was -13.5%, while the median was an intra-year loss of -10.5% over this 67-year period. There were double-digit drawdowns in more than half of all years, and one out of every six years saw a 20% or worse drawdown.
Yet, as Ben points out, despite these big and consistent drawdowns and despite the S&P going up barely 50% of all trading days, the S&P has gained over 11% per year since 1950 and has been in positive territory for nearly 80% of those years. The S&P gained 10% or more roughly 60% of the time and was up 15% or more almost half the time.
In response to this drawdown risk, we would like to think that we can time the market — moving in and out of the market and in and out of various market sectors to achieve market upside while avoiding the downside. But there is shockingly little evidence that anyone is any good at it.
For example, over the past five years (per Morningstar), tactical managers in the aggregate have underperformed the S&P 500 by more than 1,000 basis points per year. Breaking the numbers down even further, for the five years ending December 2016, the S&P beat the best tactical manager by 363 basis points per year, the median tactical manager by 949 basis points per year and the worst tactical manager by 1,750 basis points per year.
There is no way to sugarcoat those numbers. They are abysmal.
One conclusion to be drawn from these various data sets is that everyone should index. Overwhelmingly, when money goes into stock funds today, it has been going into passive index vehicles. Over the past decade, $2.2 trillion has entered passive funds while the same amount has left active funds. These facts suggest that perhaps active management needs to go in what Buffett calls the “too hard” pile.
Yet Buffett himself provides powerful disconfirmation for that idea. Just a few weeks ago, Buffett issued his influential annual investor letter and announced that his firm, Berkshire Hathaway, had returned 20.8% annually to investors from 1965-2016 (more than 50 years!). That’s more than double the annual return of the S&P 500 over that same period.
Whether you choose a great concentrated manager like Buffett, use factors with a history of persistent outperformance or another active approach, active management is far from dead. That said, difficult as it may be to find, great investing still runs the risk of suffering through very long periods of underperformance.