Peer group comparison forms the basis of many financial decisions, but many investors may not understand how these rankings are constructed and the problems embedded in such comparisons, according to Research Affiliates.
“In our view, the manner in which aggregate active manager performance is displayed, vis-à-vis index funds in commonly used peer groups, is not reality,” writes John West, director and product specialist at Research Affiliates.
Because the index reflects the activity of all investors, including the largest active managers, it would come as no surprise if it tracked their investment patterns, with the associated costs of active managers dragging down their returns.
Over the past decade — recently dubbed “The Lost Decade” — the S&P 500 Index trailed 90% of active managers, according to Research Affiliates. But this was largely due to a number of biases inherent in the peer group comparison model.
Among the best known of these biases is survivorship bias, where underperforming funds are folded and therefore disappear from the peer group.
“Surviving managers — whether at the upper or lower end of the distribution — likely did significantly better than indicated once we take into account many of the failing products that were part of the opportunity set at the time of hire,” West points out.
In 2008, asset managers were forced to focus on their most profitable funds and shut down many of their niche products. The year the financial crisis peaked saw an attrition rate of 8%, well above the 5% annual trend. In fact, since 2006, 30% of the 393 managers running large cap money managers have closed up shop altogether.
“If underperforming strategies were the ones that closed down during the recent crisis, doesn’t this artificially push up the median performance of active managers? With the dead weight gone, the S&P 500& #151; or any indexing strategy — looks less compelling against the ‘average’ large cap core manager.”
Research Affiliates also factored in “backfill bias,” the inclusion of historical data for new mandates that can add up to 140 basis points to a peer group’s returns.
There is also the fee differential between active management and passive strategies, which the group calculated to about 55 basis points. Taking these three factors into consideration, active management appears to have returned more like -0.15% annual growth rate over the past decade, compared with the -0.95% return of the S&P 500.
This perceived outperformance is on the institutional side, where scale gives the investor some power to negotiate fees. Individual investors in the mutual fund world should be so lucky, West points out.
“Studies of mutual fund peer groups — which are reported net of all costs — tell a completely different story for the S&P 500 during the 2000s,” West writes. “Even without adjusting for survivorship bias, the S&P 500 ranks in the 60th percentile in the Lipper peer group and in the 50th percentile for the Morningstar peer group.
“Adjusting for survivorship bias in the mutual fund peer groups would place the S&P 500 squarely better than the average active fund for the 2000s.”