Do active funds really underperform?

The lie of statistics and cherry picking

July 18, 2021

Snir's investing desk is a newsletter focused on intelligent, value investing for the individual investor. The subjects are evergreen and deals with the essence of investing, mental models, and concepts.


"Most active funds underperform the benchmark" is a typical headline you'll see when the question of active vs. passive arises. If that's true, and the professionals are losing in masses, then it will be even worse for a retail investor. So should we invest in index funds and forget about active investing?

Well, not so fast. This title is manipulative at worst and deserves the rank of "not even wrong" at best. Because it is technically correct, while it shows a false image. Let me explain.

The underperformance research

"Eye grabbing titles"

Eye grabbing titles

Behind all the eye-grabbing titles that either drive clicks or helps sell a product through fear-mongering, there are two official pieces of research.

The first, and more prominent one, is the SPIVA (S&P Indices Versus Active) report. It is the more prominent one because this report coming out every year for many years now - and every year, it goes onto a PR campaign driving the same titles.

The SPIVA report is funded and done by "S&P Global". This company profits from its market indices - the same indices they compare in the research. The report is written such that it's easy to know what indices are used but impossible to figure out the funds compared to them.

It's obvious they make the report as a marketing campaign for their indices. Yet, it doesn't mean the data is wrong - just cherry-picked to drive a conclusion far-reaching what it really represents.

The second research was done by some researchers in the economic group of the University of Chicago, called "Mutual Fund Performance and Flows During the COVID-19 Crisis". This one is more thorough but essentially checks the same things with similar variables.

What the research says

Both papers (and many other like them) take performance metrics of public funds and compare them to an equivalent benchmark. The equivalent benchmark is dependant on the fund characteristics - if a fund mostly invests in small-cap, it will be compared to a small-cap index.

With this comparison, you consistently get a familiar result: active public funds consistently underperform their index funds equivalents.

But that does not mean that stock picking by professionals consistently loses or that active investing, in general, is less favorable to index fund investing. It's all in the definition of the variables.

What are the "public funds"

The research conclusions are that the funds it looks at are underperforming. I claim that those funds that they look at are unrepresentative and set up for failure by their structure. Thus - these researches will always get the same results, and companies can weaponize these results for marketing purposes.

There are many types of funds. Public funds are just a subset of them - and on top of that, public mutual equity funds are an even deeper subset that these researchers focus on.

Public mutual funds are set up to trail the benchmark by their structure. Regulations force the fund managers in one direction while showing results publicly every quarter denies them the ability to make long-term plays. The reasons for mutual funds failures are vast but out of scope for this piece, but there is an article on the Nasdaq site that covers it extensively.

To compare index funds to active investing in the real world, we need funds with no strings attached: no strict regulations that force them to do certain things and bargaining power over their customers.

This exists in private funds alone.

Private funds

Private funds, by the definition of their name - are private. That's why you'll never see them in those researches and why we can never know how they perform in aggregate.

We are talking hedge funds, family funds, and many other types of private funds. Today, most super-investors operate in private funds - Guy Spier, Mohnish Pabrai, Michael Burry, etc.

Even though we can see some of these investors' actions in the SEC-mandated 13f filings, those only include outright shares purchases in the American market alone. Any derivative activities or international operations are hidden.

Derivatives

But surely, if these funds are so big, we will see all of them in the shareholders' stats of companies, as regulation mandates. Well, no. Many private funds utilize derivatives and other tools to hold ownership of the stock price changes without owning the stock itself.

Such is the story of Bill Hwang of Archegos Capital. Since 2012, he turned $200M into $20B - 1,000x in 8 years. But the only reason we know about it is that the fund blew out due to margin calls on risky bets.

Archegos Capital held such a massive percentage in some companies that they should have triggered regulations showing their name as significant shareholders. But the name never showed anywhere - they bought all their shares through bank derivatives. So the tangible shareholders all this time were the banks.

If Bill Hwang wouldn't blow out - we might have never known about his existence, let alone his massive holdings. Now consider how many are out there that never blew out.

Performance

We don't know the performance of private funds in aggregate, and any anecdotal point will be meaningless.

The only thing to our aid is the "metadata" - if active investing didn't work, all the wealthy families and personals in the world would not have used them. But they do.

That's not to say that active investing is easy - it's not. But if we want to talk about odds and whether it's a viable pursue for the intelligent investor - it might be.

Conclusions

Public mutual funds are underperforming their benchmark because they are structurally built to do that. But that doesn't say anything about active investing as a whole. The majority of active investing in the world is done in private funds, so we can't know how well they do when compared in aggregate to indices.

That idea that "active investing is playing against the odds" came mainly from the mentioned researches. But it's wrong. At best, we can say "using public mutual equity funds is playing against the odds".

Active investing, especially done intelligently with proven methods (a la Buffet and Munger, for example), might be playing with the odds stacked in your favor.