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  • Bogleheads on Investing with Craig Lazzara: Episode 50

Bogleheads on Investing with Craig Lazzara: Episode 50

Post on: September 27, 2022 by Rick Ferri

For our 50th Episode of Bogleheads on Investing Podcast, host Rick Ferri interviews Craig Lazzara, CFA, a Managing Director in the Core Product Management group at S&P Dow Jones Indices (S&P DJI). His responsibilities focus on providing thought leadership and educational outreach. Our discussion focuses on two S&P DJI reports. SPIVA research measures actively managed funds against their relevant index benchmarks worldwide, and the Persistence Scorecard focuses on whether manager outperformance should be attributed to luck or skill. Craig holds a Chartered Financial Analyst charter and is a graduate of Princeton University and Harvard Business School. 

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Rick Ferri: Welcome everyone to the 50th edition of Bogleheads on Investing. Today our special guest is Craig Lazzara. Craig is the managing director in the Core Product Management group at S&P Dow Jones Indices, where his responsibilities focus on providing thought leadership and educational outreach. Today we're going to be discussing the SPIVA report, S&P index versus active.

Hi everyone. My name is Rick Ferri, and I'm the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C Bogle Center for Financial Literacy, a 501(c)3 nonprofit organization dedicated to helping people make better financial decisions. Visit our newly designed website at Bogelcenter.net to find valuable information and to make a tax deductible contribution.

And don't forget about our Bogleheads conference, coming up this October 12th through the 14th, featuring many speakers that I've had on this podcast, and more.

Today our special guest is Craig Lazzara. Craig is the managing director in the Core Product Management group at S&P Dow Jones indices, where his responsibilities focus on providing thought leadership and educational outreach. Today Craig and I are discussing something near and dear to the Bogleheads heart: the active versus passive debate.

Should you only be using index funds, or should you be using only active funds, or should you be using a mixture of active funds and index funds?  There's over a hundred years of data on active management versus index returns, and this data has been remarkably consistent through the entire 100 year period of time. Today we're going to be looking at the last 20 years where S&P has been publishing their detailed index versus active report and a second report which analyzes the persistence of outperforming actively managed mutual funds.

So with no further ado, let me introduce Craig Lazzara. Welcome to the Bogleheads on Investing podcast Craig.

Craig Lazzara: Rick thank you, I'm delighted to be here.

Rick Ferri: Craig we've known each other for a long time and you've been at S&P Dow Jones indices for a long time. And I want to get into a little bit of your background as to what brought you there. But in order to talk about S&P Dow Jones indices I think we need a little explanation of who is S&P Dow Jones indices and why is it S&P Dow Jones rather than just S&P?

Craig Lazzara: Well as you suggest Rick there's originally two different entities. S&P, of course, stands for Standard and Poor's, and the roots of the Standard and Poor's company go back to the, I think, the 1860s when Henry Varnum Poor published the first railroad ratings. And S&P obviously is well known for its ratings business. 

There was a company called Standard Statistics that I believe in 1923 began to publish an index of the U.S stock market. I think it had a relatively small number of names and it was the first capitalization-weighted index ever computed on a daily basis. And I believe that was 1923. Somewhere along the line, the Standard Statistics company and Henry Varnum Poor's ratings company merged. That's where it came to be Standard and Poor's. 

And then this initial cap-weighted index product that I mentioned that started in 1923 morphed by – we added names, they added names as computing capabilities allowed – but in 1957, I believe in March 1957, the Standard & Poor's company launched what was called then the Standard & Poor 500, now the S&P 500. And so the history of the 500 goes back to March 1957. And that obviously has come forward from there.

On the other side of the merger Mr. Dow Mr. Jones started publishing their iconic indices, I think in the 1880s. The Dow Jones Industrial Average started I believe in 1896 but the Transportation Average is actually a bit older than that. Those were price weighted, meaning in the days when the only computational equipment you had was a piece of chalk and a blackboard, you could add up the names or the prices of I think it was a dozen stocks to begin with and divide by 12 and get your answer.

So the Dow company, it'll continue to evolve and obviously, as indices and index funds became more important in the investing landscape, both companies developed substantial businesses in licensing indices for the creation of investment products. In 2012 what was then called S&P Indices acquired Dow Jones Indexes and formed S&P Dow Jones Indices which is technically now a joint venture company about three quarters owned by S&P Global, which is the parent company that evolved out of the old S&P, and one quarter by the Chicago Mercantile Exchange. So we've been S&P Dow Jones Indices since 2012. 

Rick Ferri: It's interesting because both S&P had a total stock market index and Dow Jones had a total stock market index. And I think the difference between the two indices even though they both have 4,200 names--one of them might have 4201 names and the other one might have 4,200 names. I mean they're so similar. But when you're looking at something like the Fidelity Total Stock Market Index or iShares Total Stock Market Index, one of them actually tracks the S&P Total Stock Market Index Fund and the other one tracks the Dow Jones Total Stock Market Index Fund--or the total stock market index I should say--and they're still very similar.

Craig Lazzara: I remember when we did the merger I was product manager for our U.S Equity product, which basically means the S&P 500. And I remember looking at those very things that you – graph the S&P Total Market Index and the Dow Total Market Index, and if you could put a spec between the graphs you were lucky. I mean they both include all the stocks you can grab hold of and they're cap weighted. So it's going to come out to the same thing if you do the numbers correctly.

Rick Ferri: Yeah, you know on this point get outside of Dow Jones S&P, and let's go to CRSP, which are the indices that Vanguard uses for their Total Stock Market. It's a University of Chicago Center for Research and Security Prices, CRSP, same thing. I mean a very, very similar tracking--almost all the same stocks--maybe entering the index coming out of the index slightly different but negligible. And then even if you look at the Morningstar Broad Market Index and all of these companies that are creating indices for say the Total Stock Market of the broad U.S market. The Broad Market would be a little bit of a smaller sub-component than the Total Market but they're all very similar. I mean the correlations are 99% and there might be a 0.1 percent difference in return, but they're all very close.

That's the history of S&P Dow Jones Indices. And what about your history? I mean how did you end up there?

Craig Lazzara: Yeah. Well, I went to college at Princeton. I majored in what we called public affairs and economics. Went from there to Harvard Business School and graduated in – well more years ago than I care to admit to, but quite some time ago. And did a year with a consulting firm in Boston, and then joined an investor management company and have been in the investment management business ever since.

Rick Ferri: And you received your Chartered Financial Analyst Charter along the way.

Craig Lazzara: Oh yeah, yeah, I  received the charter in 1983. Yes I have a four digit charter number, which as you know Rick, is pretty low.

Rick Ferri: Oh wow! Let me think --I don't know--you're ahead of me. And then you went into work in the investment industry.

Craig Lazzara: I started my career in the investment business on what we call the buy side at investment management companies, and spent a number of years at a variety of firms tending to specialize in what was then considered quantitative analysis. I think by today's standards it wasn't all that advanced but by 1984 standards it was pretty good and so I was an equity quant for a while.

And in the mid ‘90s I had the chance to join the old Solomon Brothers brokerage firm, kind of in a job that related to marketing and use of their quantitative research. Solomon had started in 1989 a set of indices that were designed to be float market cap weighted indices of the entire Global Stock Markets. I got to know that group. They were related. I eventually transferred into the department that managed and maintained those indices and those indices were ultimately acquired by Standard & Poor’s in 2002, I believe.

Now I had left Solomon prior to the acquisition but luckily I'd met a number of people at S&P and when they were looking for some senior help in 2008 - 2009 I was available and we were able to make the match. So I ended up joining S&P in June of 2009.

Rick Ferri: So now you're at S&P Indices which became S&P Dow Jones Indices and you and I have talked for many years about the results of the SPIVA report that was started 20 years ago. So let's talk about what SPIVA stands for and why this report got started and why it's important. 

Craig Lazzara: Easy question. For SPIVA stands for S&P Index Versus Active. It's an acronym. Sometimes in the UK pronounced “spiva”, so to take your pick, depending on where our listeners are. But the point of SPIVA, then 20 years ago and now, is to ask the question how have actively managed funds performed relative to benchmarks that are appropriate for their investment styles. What I mean by that is if you're trying to evaluate how large cap U.S managers have done you compare them to the S&P 500.

I want to ask how mid cap managers have done, you might compare them to the S&P Mid Cap 400 and compare growth managers to their growth index, value to a value index, and so forth. But that was the notion that underlay SPIVA in 2002 when it was first published, and then that is the notion that we continue with today.

Rick Ferri: So when you talk about managers you're talking specifically about mutual funds and exchange traded funds, correct?

Craig Lazzara: In the case of the U.S, yes it is really mutual funds, actively managed mutual funds. The data for which we access from a database called the CRSP – you mentioned CRSP earlier, the Center for Research and Security Prices at the University of Chicago – CRSP maintains what is called a survivorship bias free database of funds. It’s a mouthful to say, right, CRSP survivorship bias free database. In the initial generations of SPIVA it was focused on mutual funds. We've expanded it somewhat institutionally since then. Think of it as a mutual fund service initially and you won't go wrong.

Rick Ferri: Let's talk about the CRSP survivorship bias free database because it was an important database. This didn't exist until 1997 when Mark Carhart, who was a University of Chicago Booth School of Business PhD student, was doing a study on mutual funds for his thesis and there wasn't any good historic mutual fund database that captured all of the mutual funds going back in history because so many mutual funds merged or going out of business. So what he did with funding from Gene Fama--Nobel Laureate Gene Fama from the University of Chicago--went out as part of his PhD thesis, gathered information on mutual funds going back as far back as the mutual funds existed in the United States. And most of them have gone out of business over time. It's included in the database, so it is survivorship bias free.

And the idea of survivorship bias. Could you explain what that is in a mutual fund database that doesn't have a survivorship bias. What happens with survivorship bias in these databases?

Craig Lazzara: Let's suppose I'm working with a database that is not adjusted for survivorship bias, so it has survivorship bias built in. What that means is I'm only able to look at funds that exist today. So if I want to say, well how did these funds perform over the past 10 years, for example, the past 20 years, I'm only looking at the funds that did well enough to survive for 10 or 20 years. What you really want to do, and what this database does, as you suggest, is I want to be able to go back 20 years and say of all the funds that existed then, how did they do? Because as you pointed out, Rick, a fair number of them do not survive.

So if you examine only the returns of currently active funds you're building in a bias because you're only looking at the funds that were most successful, or to be precise, that were successful enough to survive. And we know very well that there are many funds that are not successful enough to survive. And since you didn't know which ones those were 20 years ago the only fair way to do an evaluation is to use a survivorship bias adjusted database. To go back 20 years and and see what the fund landscape was like then.

Rick Ferri: And in your SPIVA report you have all this information for all the different categories, of how much over one, three, five, fifteen, twenty year periods of time how many of these funds survived or changed styles. That's another thing that you look at as well. Some funds that say that they're large cap growth end up being something else, or maybe they start out as mid-cap core, end up becoming something else. So you also track a style survivorship.

Craig Lazzara: Yes, yeah. No, that's important. You might have a fund, let's say a successful fund starts out as a mid cap growth fund. It's successful, it begins to acquire assets. The manager thinks well if I'm going to continue to be a mid cap growth fund I've got to stop taking assets, or else maybe I should migrate up the cap scale and use larger stocks which then I'm able to deploy the liquidity that I now have access to. So yeah, that's a natural sort of thing to happen, can happen organically as funds grow or as managers change. Manager tenure is limited in most of these places so you'll – things change.

Rick Ferri: So you looked at all of this. I mean you were very unbiased as how you tried to do-- you had to do it as fair as you possibly could to try to say okay let's take these funds and compare them to this index and let's see how many survived, how many were style consistent and how many outperformed the index and how many underperformed. And here the data gets interesting because it is so consistent not only over the last 20 years, but – I've done a lot of work on this, it goes back a hundred years, how consistent this data is. So why don't you tell us?

Craig Lazzara: Yeah the quickest way to answer your question, I think the adequate answer, a good answer, is what the data show is that most active managers underperform most of the time. So if you look at the last 20 years of SPIVA for the large cap U.S manager category, which is the largest category, so that's why I picked that one. If you compare those managers to the S&P 500 year by year, I think the average is something like 64%, in an average year 64% of the large cap US managers underperform the S&P 500.

Now some years it’s more, some years it’s less. The last year in which a majority of large cap managers outperformed the S&P 500 was 2009. So, and in the 20 years of history of SPIVA, I think only three years when a majority outperformed. So the result suggests – and Rick you alluded to other research that goes back a hundred years – and a lot of research was published on this topic. And before index funds started in the ‘60s and 70’s it's a very consistent finding that most active managers underperform a benchmark that is appropriate to their investment style.

Rick Ferri: Now one of the things that occurs is that because less than 50% outperform that over time this compounds. So by the time you get out to say five years it's more than 65%.

Craig Lazzara: Exactly right. In fact we just released in early September our mid-year SPIVA, so it covers the first six months of 2022. So for the--and it was a relatively good six-month period-- only 51%  of the large cap managers underperform and that's that's really quite good considering the history. I mentioned to you going back a full year. So the year ended June 30th 2022, 55% of large cap managers underperformed. Going back five years 84% underperformed. Going back 20 years 95% underperformed. So this is again very, very common. Whenever you look at SPIVA data you see that the percentage of underperformers goes up as the time horizon extends back. You see the same thing if you look at Mid Cap managers or Small Cap managers or growth Specialists or value Specialists. Very common effect.

Rick Ferri: So this is important for investors who are long-term investors. I mean if you're going to pick an active fund the longer you hold it the lower the probability it'll outperform the indices. Or if so, if you're going to be a long-term investor, if you just bought an index fund, the longer you hold it the higher the probability that index fund will outperform the active managers in that category.

Craig Lazzara: Absolutely. Another way to say that is if you look, say, at our large cap US category where 95% of the funds underperform the S&P 500 over the past 20 years, and turn that on its head and say if you were an investor choosing a large cap fund 20 years ago, the chance that you chose one that did better than the index was one in 20. So the odds are really quite overwhelming in the historical data that the longer your holding period the more likely it is that an active manager underperformed.

Rick Ferri: But let's go to the next dimension of this and that is that small minority that did outperform, that five or ten percent that did outperform, they didn't outperform by very much relative to the 90% that underperformed. And the reason I say this is because if the payoff for picking a manager that outperform was like 10% a year excess return then it might be worth trying to find those 10% managers because the payoff is so great. But that's not what happens. The payoff if you actually find one of those 10% is significantly smaller than the 90% that underperformed, how much they underperformed by. So not only is it very difficult to find managers who are going to outperform--and we'll get into that in a bit--but the payoff for doing it, you're not getting paid.

Craig Lazzara: Exactly. I mean the odds are against you. I mean I think that's a fair thing to say to an investor who's contemplating “should I invest in an index fund or in an active manager who follows the same style.” If you want to invest in an active manager that's fine but realize the odds are against you.

Rick Ferri: So there's a low probability of picking a manager and then the payoff is low. You also, though, look at this and say well some of those funds that are not performing well don't have much money in them so why are we even counting them in this study.

So you actually do the study two different ways. You do it based on equal weighting all of the funds as though all these active funds have the same amount of money in them, and then you do cap weighting, which is okay, let's look at the funds and see how much money there's actually in there. So we can really find out what the investor experiences. So could you explain the difference between the two.

Craig Lazzara: If I'm trying to answer the question how did the average large cap manager do I've got you know let's say a thousand--I'm making the number up--there are a thousand funds to evaluate. One way to do it, as you say, to take the returns of all one thousand, add them up, divide by a thousand. That's equal weighted. The problem with doing that is that you may have some funds that control 50 billion dollars and another fund that controls one billion dollars and you're treating them as if they're equally important.

So the other way to do it is what we call asset weighting, where you weight each fund's return by the amount of money or the amount of assets that the fund has, and then divide by the total value of all the assets across all the funds. So that gives you an asset weighted rate of return. And the difference between those numbers will tell you whether the larger funds are doing better or doing worse than the smaller funds. If the asset weighted number is 12% and the equal weighted number is 10%  that tells you the larger funds, really some of them, the larger funds did better. And the reverse, if the numbers are reversed.

And over the long enough time horizon what you quite often see is that both the simple average and the asset weighted average return of these funds is less than that of the index to which is being compared.

Rick Ferri: But how much of a difference is it? I mean is it better to get in bigger active funds than smaller active funds.

Craig Lazzara: Depends on the period. I don't think I could make a blanket judgment about it. This last six months, for example – I mentioned we just published SPIVA for the first six months of 2022 – the last six months the asset weighted average did less well than the equal weighted average, meaning the smaller funds did better. But there have been years when the reverse has been true.

Rick Ferri: So it's probably pretty equal then over time?

Craig Lazzara: I would think so, yeah.

Rick Ferri: And you've also done--you've added this over the last few years--you tried to do some risk-adjusted numbers. So you're looking at Sharpe Ratios which is a function of adjusting for call it the volatility of the funds. And what that has shown is that, in other words, are the active funds even though they're underperforming, they're less volatile. Is that a factor? 

Craig Lazzara: No, that is in fact just the opposite. The average actively managed fund in the SPIVA database is more volatile than the index to which it's being compared. Tim Edwards and I did a paper about this some some years ago now it's called The Volatility of Active Management. It's very clear that most active managers do not produce less risk than the benchmarks that you're comparing them to.

The one thing that is particularly interesting about that paper, as I'm recalling it, is that unlike returns, where a manager might have good returns one year year and bad returns the next and that fluctuates, the volatility profile of funds is fairly stable. So if you have a fund that is relatively more of I'll say a large cap fund, a relatively more volatile than the S&P 500 this year, it's probably going to be more volatile next year, and the year after that, and probably the same for the years in the past. So there's some stability in volatility of active funds. But there's no--I mean some funds, yes, are less volatile--but the majority are not.

Rick Ferri: So you've also done this for International equities and for U.S bonds. So let's start with the international equities first, which is a completely different database. I mean you're in a completely different market, has nothing to do with the US, nothing to do with the original U.S SPIVA. Is the data the same?

Craig Lazzara: The conclusion is the same. Yeah. I mean we can--I can answer the question really in two ways. One is that as part of U.S. SPIVA we look at international funds or global funds that trade in the U.S. So same database, and that gets you the same answer. But then … our business has expanded internationally. Other clients in other regions have said, well what about Canada, what about Europe, what about Australia. And so we've begun to publish-- we have now published SPIVA, I think, in 10 or 12 different regions. Europe, Australia, Latin America, Canada. I'm sure I'm leaving things out-- India. 

And the conclusion is remarkably consistent. I mean there are exceptional years, yes, in all these places. But if you look at long periods of time, even an interval as short as five years, the majority of active managers underperform a benchmark that is appropriate to their investment style. It's very, very consistent.

Rick Ferri: So let's go back, circle back to investors here in the U.S are investing in International, in foreign stocks through foreign mutual funds that are managed here in the U.S.

Craig Lazzara: The conclusion is the same, yeah. There's no evidence that the managers of international funds do any better than the managers of a domestically focused fund.

Rick Ferri: Okay. I have to ask you this because a lot of people say, well yes, but not in Emerging Markets. I mean Emerging Markets, you can go out and you can find active managers that are going to outperform. I mean do you find that to be true?

Craig Lazzara: Well some, sure. But there's no consistency there either. I mean I think the thing that makes SPIVA results what they are is that in most markets, including Emerging Markets, including all the international markets I mentioned, in most markets the investment business is very largely institutionalized--most of the money is controlled and managed by institutional, by which I mean mutual and pension funds, endowments--you know, professional asset managers. Which means that the managers of Emerging Market funds or the managers of Canadian funds, or the managers of U.S funds, are competing against other professionals who have the same skill set, information access, computational ability, and knowledge of the markets there.

It's a fair game. It's not like it might have been in the ‘50s, for example. It's not like one set of investors, the professionals have access to information and trading data that is superior to that of the others and so the ones with superior knowledge can take advantage of the ones with less knowledge. Here it's professionalized pretty much across the board.

Rick Ferri: Well here in the U.S anyway.

Craig Lazzara: Certainly in the U.S, and increasingly globally too.

Rick Ferri: Yeah. Well let's get into fixed income. So you also do this with fixed income. You look at treasury indices versus managed treasury funds and corporate bond funds versus corporate bond indices. And does the data hold there?

Craig Lazzara: Yes. Although I would say it's more volatile there because in the following sense if you're in an environment where interest rates are increasing, as we have been now, if most fixed income managers have a duration in their portfolio that is less than that of the index to which they're being compared, then the majority can outperform in periods when rates are increasing. And they will then underperform in periods when rates are decreasing.

So the importance of the maturity/duration decision, what's the average maturity of the bonds of the portfolio is what I mean by duration. The importance of duration in fixed income analysis is just overwhelming. If you get that decision right you can get a lot wrong and still be a really good bond manager. And because it's so important, I think you see more fluctuation, you'll see in some categories a larger majority outperform one measurement period and then underperform the next measurement period, simply because the direction of interest rates is changing.

The other thing to keep in mind about fixed income markets, certainly government treasury markets in particular, is unlike the equity markets where basically all of the players are what an economist might call rational profit maximizing--I'm trying to make a lot of money you're fund you're trying to make a lot of money---in the fixed income market there is one very large player who is not a profit maximizer, or that being the Federal Reserve. So you have another presence in fixed income that sometimes, depending on his interest rate decision, sometimes helps the manager, sometimes hurts the managers. But there is this other factor which you don't see in the equity world.

Rick Ferri: I guess it would also be a little different because the dispersion of returns among bond managers is going to be much narrower…

Craig Lazzara: Much, much lower.

Rick Ferri: Than the dispersion of returns of equity managers.

Craig Lazzara: Yeah, very much so. In fact there's a David Swenson--the late head of the Yale endowment- I think at one point was quoted as saying the difference in performance between a top decile bond manager and a bottom decile bond manager was so small that it wasn't worth your time to try to figure out who was who.

Rick Ferri: Very good. Okay. So SPIVA, congratulations on 20 years of data. I will say that I've been following this market for 30 years, 35 years, and it's remarkable that what S&P Dow Jones has done, your data has correlated so highly with others, like Morningstar does the same study and the same results. No they might use different indices, but it's the same result. And Vanguard does an annual study too and it's the same result. And they're using different indices, but again, it doesn't really matter that much. The results all come out to about the same and the results are this: Can active funds beat the benchmark? The answer is yes, but not many, not by much, not for long, and the winners are not predictable.

And with that let's get into the second study that you do which is called a persistence study. So tell us about persistence?

Craig Lazzara: Okay. The persistence scorecard, so-called, uses the same database as SPIVA, so it's the same CRSP survivorship bias free database. And the question that we asked in the persistence scorecard is really very simple. It says, for example, let me identify all of the funds who were above average two years ago and say of those that were above average two years ago how many were above average last year? You go back five years and say of those who are above average five years ago how many were above average four years ago, three years, two years ago and so forth.

Rick Ferri: So what you're trying to measure here then is does the outperformance carry forward?

Craig Lazzara: Exactly. Recognizing that only a minority of active managers outperform in a given year. If I focus on the more successful active managers from this in the historical data will I be more successful going forward. The simple way to say the question that the persistence scorecard tries to answer is do winners continue, do losers continue, is there persistence in skill?

Rick Ferri: Or does it ask is there actually skill or is it randomness?

Craig Lazzara: The way to think of it is this. When you identify a manager who has outperformed how can you tell whether his outperformance is a result of genuine skill or simply of good luck. And the answer to that question is genuine skill should persist. Good luck is ephemeral, comes and goes, you're lucky this year, not last year, or not next year. And so what the persistence scorecard does is to – at various time horizons and various break points – look at funds which have outperformed historically and asked did their outperformance continue.

For example, there are many many cuts in the persistence scorecard. One thing we do is to say let's go back with 10 years of data, take all the managers who were above average in the first five years and say how do they do in the second five years. And obviously if you were in the top half of the universe five years ago, in the first five years, and skill persists, the likelihood is you should have a lot higher probability of being in the top half of the distribution in the second five years than the managers who were in the bottom of the distribution in the first five years.

And what the persistence scorecard tells us is that there's relatively little persistence. In other words the example I just posed, the last time we ran persistence, if you take again all large cap managers, go back 10 years, take the first five years and say of the managers who were above average in the first five years how many of them were above average in the second five years. The answer was 42 %.

Rick Ferri: So less than half. So this is like a random event. I mean if you think about it it's like well, it seems like half should be at least half of it.

Craig Lazzara: Yeah. No, exactly right. That's the default, is half. In other words, if the results are completely random, half of the managers are going to be in the top half and it turns out that somewhat less than half of the top half managers from 10 years ago are still in the top half in the second five year period.

Rick Ferri: Now what about the bottom half? Did any of the managers in the bottom half end up in the top half.

Craig Lazzara: Oh sure, sure.

Rick Ferri: Well I'm actually looking at the data right here and it does look like the bottom half a little less than 20% of the bottom half ended up in the top half, but about 15% of the bottom half ended up going out of business, whereas the top half only about 6% went out of business. So I guess what you could say about the top half is that the lower probability they will merge or go out of business. They have that momentum probably because they have a lot of assets in the fund if you're in the top half.

Craig Lazzara: Yeah and there's some persistence, I think not in performance, but of a stickiness of funds. If you're in a fund you may not want to get out for a variety of reasons.

So if historical success, if you look, let's say at the large cap funds and do this five-year exercise. If you're in the top half in the first five year period you're less likely to go out of business or to liquidate. You're not particularly likely necessarily to repeat in the top half, but you're likely to live, to persist in terms of still being around.

Rick Ferri: Now you also divided these down into quartiles. So you can look at the top quarter and then the second quarter, and then the bottom three quarters and then the bottom quarter. And it doesn't appear overall that it's much different than random, what happens to a fund. 

Craig Lazzara: So that's a very fair summary, again coming back to the way the exercise works if skill is randomly distributed, or results are randomly distributed. In any given period 25% of the matters are going to be in one in each court in the top quartile. So if you look at large cap US managers again and say look in the first five years what percentage of large cap U.S managers who were in the first quartile in the first five years repeated in the first quartile the second five years. The answer again, the most recent persistence scorecard was about 27%, not really much better than random.

Rick Ferri: Random?

Craig Lazzara: Yeah, and if you go to look at Mid cap and Small cap it's even worse.

Rick Ferri: A manager who has skill like a bowling team or a top tennis player should continue, I mean you know they should continue to win.

Craig Lazzara: Exactly. The fact that the persistence score says what it says, in other words, that there is no predictive value in historical performance. I mean I think it says two things, Rick. One is it reminds us that what active managers are trying to do is very difficult. It's so difficult that most of them don't do it particularly well. And secondly it reminds us as investors who are potentially identifying funds to buy, that historical performance is not a good gauge of what will happen in the future.

Rick Ferri: Some have said that fees are a good indication. In other words if you have low fees you have a higher probability of outperforming. Do you work any of that into your studies?

Craig Lazzara: Yes. There’s a – I guess I'll give you an answer on two levels. One we haven't done the study directly. I know Morningstar has and the summary is exactly what you say. If you were instead of picking a fund based on past performance, if you pick the fund based on I want something in the lowest quartile of fees, that's a more sensible strategy than picking a fund that has outperformed by a lot recently.

What we have done in SPIVA is--and we don't do it every every six months, but we'll every year do what we call an Institutional SPIVA--and what we do in Institutional SPIVA, among other things, is to take all of the funds that were in the SPIVA, of classic SPIVA, that we were talking about, and add back their fee.

Rick Ferri: Oh, you do a gross, you do a gross of fees.

Craig Lazzara: Now not surprisingly, somewhat fewer managers underperform when you don't count their fees. But it's still a majority.

I mean I remember the very first Institutional SPIVA came out. I remember doing a meeting with a client and so well I'll make it as simple as I can. SPIVA tells us, classic SPIVA tells us that most mutual fund managers net of fees underperform most of the time. Institutional SPIVA tells us that most institutional managers and most mutual fund managers gross of fees underperform most of the time. The conclusion doesn't change. I mean the numbers change a little bit but the conclusion doesn't change really at all.

Rick Ferri: That's interesting. I wonder how much of that is related to just the amount of cash that they have, and have to have in a portfolio. And you know bull markets occurring at times when there's cash in a portfolio, which is hurting performance, and you know kind of an asset allocation decision as opposed to his stock selection decision.

Craig Lazzara: Part of it could be that. But we've done some work on this topic because we hear this objection all the time. Well, you know that index funds will outperform because they're fully invested in a rising market, but not in a falling market. And if you look back at the falling markets and our historical database, look for example at 2001 - 2002. The majority of managers underperform. 2008 the majority underperformed. So the data don't really support.

Rick Ferri: Can't make that argument about cash then?

Craig Lazzara: Yeah. I mean I think there's a slight advantage, sure. The other thing to keep in mind, of course, is that that we are at a point in in the investment business now where sophisticated mutual fund managers, which I would think would include most if mostly not all of them, there are ways to equitize your cash if you have you to have a lot of cash on hand because you might get redemptions. Well you can buy index futures to so-called equitize the cash, giving you the return of the equity market. So I think that that wasn't possible 50 years ago certainly, but certainly it is today. And I also think that also rebuts that argument.

Rick Ferri: Past performance is not an indication of future results, is really what the persistence studies are.

Craig Lazzara: That is a very good summary, yes.

Rick Ferri: A lot of it is random. Skill is very difficult to discern. Very hard to go out and pick a manager that actually has skill, and I get – one of the problems with trying to pick a manager that has skill is that everyone is looking for these managers. And if you actually identify somebody that has skill, that money is going to just pile in and that in itself could harm the performance of the fund. We see that quite frequently.

Craig Lazzara: One thing I think we know for sure about fund flows is that the vast majority of fund flows come into funds that have recently done very well. So especially if you think back to what you just said Rick, that past performance is not a good indicator of future performance, to allocate money based on past performance is just saying you're almost asking to underperform and of course that's what happens. It's understandable. People want to buy something that has done well. Except that the fact that it did well last year does not tell you much about how it's going to do this year.

Rick Ferri: So let's talk about a report that I did that you've read. So as an advisor for 35 years, if I just took client money and allocated it between stocks and fixed income, and then within the stock side the U.S stocks, International stocks. And on the fixed income side treasury bonds, corporate bonds or Total Bond Market Fund. And all I did was buy the cheapest index fund I could get on the U.S stock side, a Total Stock Market Index Fund or even an S&P 500 Fund. On the international side a Total International Fund. On the bond side a Total Bond Market or if I wanted to have a municipal bond fund a Municipal Bond Index Fund or something similar to it because Vanguard actually has actively managed Municipal bond funds that should basically be index funds because there's so many bonds in there.

But if that's all I did--what the study that I did which is called The Case For Index Fund Portfolios which actually came out 10 years ago with Alex Bankey as the co-author. If all you did was buy a portfolio of index funds and nothing else. Forget about trying to pick active managers. Forget about trying to pick managers who are going to outperform the international market or the small cap market or whatever. Just forget it. Just buy all index funds, the cheapest you can, and maintain your asset allocation. The probability of the portfolio outperforming a portfolio that has either all active funds or some active funds in it is well over 90% and it's even higher in a portfolio sense than it is in each one of these silos like large cap, mid cap, small cap. When you put it all together in a portfolio the probability of the portfolio outperforming a portfolio with active funds in it is actually higher than the individual silos because there might be a couple of active funds that you own that outperform but the underperforming funds drag everything down.

So I've been pounding the table on this, and of course, Jack Bogle did for years, and the Bogleheads pound the table on this. Just put together a few good index funds in a portfolio and hold it for the long term and you'll be far better off. Do you agree with that?

Craig Lazzara: Absolutely, absolutely. I mean I think the mistake people make and then you what you addressed in your in your study, Rick, with the mistake people make is to say that diversification will help me so I'll pick an active U.S fund, for example, or maybe two active U.S funds, and then I'll diversify by picking an active International fund, an active bond fund and so forth. And the difficulty is that that works if the expected return or the expected benefit of buying those active funds is positive. But if the expected benefit of buying the active funds is negative – which SPIVA and other research demonstrate very clearly that it is – you're basically compounding the mistake.

I mean another way to say that is let's suppose I go into a casino. I go up to the roulette wheel and I put ten dollars on red and I spend, lose my money. And the next roll I'm going to put ten dollars on black, now because I'm going to diversify. I mean it's you're not diversifying anything except randomness. What you identified in that paper, which is really important, is – to my mind – conceptually a similar argument to the reason why SPIVA results are so much worse over a 20-year horizon than over a one-year horizon and that is that the probability of success is less than 50%.

I am a lousy basketball player. So let's suppose that I was to get into a free throw shooting contest with Michael Jordan. It's possible he might miss his first shot. It's possible I might make my first shot. So as the unskilled player I don't want many – if we have to shoot 100 free throws he's going to beat me easily. Easily, even 10, he's going to beat me easily. But I might get lucky the first time or the second time. So if you're a low-skilled player you don't want many trials. You want relatively few.

Rick Ferri: You want to rely on luck.

Craig Lazzara: You rely on luck. If you're a high skill player you want lots of trials. And so in SPIVA's case lots of trials means let's look not at one year but at 20 years. In the case of your paper lots of trials means let's look at multiple asset classes, not just one asset class. But they both point to the same conclusion which is that the probability of success in picking an active manager is less than even. That's why the results get worse over time. That's why the results get worse when you use more asset classes.

Rick Ferri: I think we made the conclusion in the paper that if you were going to go with active management you put all your money on red and spin the wheel, like you're saying, the more active managers you put in your portfolio the lower the probability is that that portfolio will outperform a portfolio of index--it's already low to begin with-- but as you add more active funds the probability actually decreases.

And I'll just tell people that you can find this paper at my website at rickferri.com. It's A Case For Index Fund Portfolios. Again the paper is 10 years old now, and was published in 2012. But the results are the same. In fact if we were to redo the study, or someone was to redo the study right now going back 10 years. I think you find that the case for Index Fund portfolios was even higher, absolutely, than it was with what we found in our paper.

Let me ask you about taxes. Now I know that you don't include taxes in your SPIVA report, but you probably have done some work on taxes because a lot of individual investors have taxable accounts and they have to pay taxes on capital gain distributions for mutual funds. So has S&P Dow Jones done any work on after tax returns?

Craig Lazzara: We have not done it ourselves. I've certainly read some of the literature and your question is the right one. The thing to remember about index vehicles is that they typically are much more tax friendly than actively managed vehicles, especially if you access them via an ETF, which has considerable tax advantages relative to a traditional mutual fund. And since it's almost any index fund that you want to have access to, it can be got via an exchange traded fund. I'm not a tax authority or a tax lawyer but it's what I do personally and I could certainly recommend it as something for clients to think about.

Rick Ferri: Yeah it's interesting. You’d think that we're off going on a little different topic here but in my own personal portfolio I only have exchange traded funds. Now Vanguard's a little different because the ETF and the mutual fund are all the same. It's all the same. They're all treated the same for taxes. But if you're going to buy an iShare or a Spider or a Schwab fund you're better off in a taxable account with the ETF because it doesn't spin off capital gains at the end of the year. You only have to pay capital gains when you actually sell your shares. You do have to pay taxes on the dividends but not the capital gain distributions that you would see a lot in actively managed funds. So again actively managed funds in a taxable account creates another cost because of the capital gain distributions at the end of the year. And so all index funds all the time, whether it's your retirement account, whether it's a taxable account. If you're going to use it in your taxable account, using an ETF certainly makes sense. Any parting words for our Bogleheads listeners?

Craig Lazzara: I think the thing to keep in mind, and we've written about this a number of times at S&P, is two things. One is the conclusion we've been talking about for the past hour or so, which is the majority of active managers underperform most of the time.

The second thing to keep in mind is this is not a coincidence. It's not random that this happened. There are good reasons why this happens. We've talked a little bit about cost. I mean index funds are cheaper than actively managed funds. I think the Investment Company Institute estimates every year the weighted average cost of U.S actively managed funds versus index funds. It's about a 60 basis point difference, as of the most recent estimate. That means, on average, an active manager starts 60 basis points in the hole. It's a lot to make up. 

A second reason ,again we mentioned this earlier, is the notion that in most of the world, certainly in the United States, the investment management business is very largely professionalized. If you hire an active manager, let's say from from Fidelity, and he's making a trade against an active manager, let's say from JP Morgan, the guy from Fidelity and the guy from Morgan have access to the same information. They read the same research, they have the same Bloombergs on their desk. They probably went to the same MBA program. They have the same CFA certificate. There is a level playing field. There's no reason to assume that one of these guys has an advantage over the other.

And that phenomenon of the professionalization was identified in a famous article--it's famous in the index world-- by Charles Ellis in 1975 called The Loser's Game. What Charlie did in that article, he surveyed the then post-war history of U.S financial markets so that was 30 years in 1975. And this is exactly what he said. In the ‘50s, say, when the investment business was largely dominated by retail investors and relatively few professionals it was possible for the majority of professionals to outperform because they had advantages that the retail investor didn't have. As the business became increasingly professionalized in the ‘60s and ‘70s, that advantage went away. Because all of the managers got better. The professionalization took over and we got to the point, even in 1975, let alone today, when it was impossible for any particular active manager consistently to have an advantage over the others.

That's why, by the way, index funds started in the 1970s. Because professionalization was well along by then. Some of the other arguments were just as good 20 years later, but 20 years sooner. But that's the thing that happened. So the fact that the majority of managers underperform most of the time is not random. It's not just a quirk of fate. It happens for very good reasons. Those reasons still exist, which means that the phenomenon is likely to continue to exist going forward.

Rick Ferri: So even though past performance is not a predictor of future returns, I feel safe saying that if you're in index funds the future performance of index funds is going to be higher than actively managed funds. In this case past performance does predict future returns.

Craig Lazzara: I think that's a very fair statement. Yes.

Rick Ferri: Thank you Craig so much for being on Bogleheads on Investing.

Craig Lazzara: Appreciate it. Thank you Rick.

Rick Ferri: This concludes this episode of Bogleheads on Investing. Join us each month as we interview a new guest on a new topic. In the meantime visit Boglecenter.net, Bogleheads.org the Bogleheads Wiki, Boglehead's Twitter. Listen live each week to Bogleheads Live on Twitter Spaces, the Bogleheads Youtube channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get others to join. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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