Businessman pointing at chart (Image: Thinkstock)

Why do actively managed funds repeatedly underperform their passive counterparts despite their ability to manage risks, which index funds don’t possess?

That’s the question that analysts at S&P Dow Jones Indices posed in their latest SPIVA (S&P Indices Versus Active) scorecard. It’s especially relevant at a time when strategists are counting down the days when the second longest post-World War II bull market will end, many recommending active management because unlike passive investing it can adjust portfolios to manage risk.

The researchers compared the risk-adjusted returns of actively managed domestic and international equity funds to their market benchmarks net of fees and before fees (gross-of-fees returns), then calculated the percentage of funds in each category that on average outperformed their benchmark index over five, 10 and 15 years.

Whether including or excluding fees in the calculation, almost all categories of actively managed domestic equity funds underperformed their respective benchmarks on average over intermediate (five years) and long-term investment horizons (10 and 15 years). The underperformance ranged from roughly 70% to 95% of domestic stock funds.

Large-cap value funds and real estate funds were the exception. During limited time frames — 10 years for large-cap value and five and 15 years for real estate funds — more than half of those funds outperformed their benchmark indexes when fees were excluded from the calculation. Net of fees, however, they also underperformed.

A somewhat similar pattern emerged for two categories of international funds. Excluding fees, 57%  of international funds benchmarked to the S&P 700 index outperformed the index over five years and 59% of international small-cap funds outperformed their benchmark over five and 10 years. When fees were included in the calculations, the outperformance disappeared.

Percentage of International Equity Funds Outperformed by Benchmarks - Risk-Adjusted Returns

“Fees contributed meaningfully to the underperformance of international funds and international small-cap funds,” the report noted.

Actively managed bond funds more than any other category showed the best performance compared to their benchmarks.

Net of fees, 80% of investment-grade long bond funds on average outperformed the Barclays U.S. Government/Credit Long index over five years and gross of fees multiple categories of bond funds outperformed their benchmarks over five and 10 years. More funds outperformed over the five-year period than over 10 years, and roughly 53% to 94% of funds outperformed their benchmarks.

“In fixed income, fees were the biggest detractor from performance, not risk,” according to the study.

— Check out Arnott: ‘Buy High and Sell Low With Index Funds!’ on ThinkAdvisor.