How Many Money Managers Beat Their Benchmarks?

Welcome to "The Informed Investor," where we break down the latest financial headlines, bringing in research and insights to help you separate the news from the noise. Welcome to "The Informed Investor," a show brought to you by Dimensional Fund Advisors, a global asset manager bringing financial science to investing. Today's topic is Assessing Manager Performance. I'm Mark Gochnour. I'll be joined today by Wes Crill and Jake DeKinder. And I said, I guess the topic being assessing manager performance. It's also maybe some considerations you also want to bring into the evaluation of a manager, in addition to just performance. We'll dive into some of that here today. Any thoughts though as we get into it? Well, it's not just the performance, it's the why, and understanding that, 'cause then I think that helps you form appropriate expectations going forward of, are there ways to add value, and are things that, all else equal, detract from adding value? Yeah, what I love about the fund landscape in general is just that it's so much of a demonstration of some of the principles we've talked about in the past with well-functioning capital markets, prices that are loaded with information, very difficult to outguess. It sets up this set of predictions that show up quite a bit in terms of the fund data. One of the point I'll make on that is it's interesting as we get into this, when we look at the performance of some of these areas, I think we'll touch on this. Why does it still persist within the industry? And I think that's important to unpack. All right, well that's a great intro here to some of the headlines we wanna start with. So let me read these headlines, then we'll dive into it. The first one. "What short-term fund performance tells us about future returns?" And then the second one, "How smart people screen for funds." Now in this case, we're talking about funds, we're talking about mutual funds, we're talking about ETFs, both on the stock side of things, as well as on the bond side of things, right? So, hey, one of the things that we're gonna be referring to quite a bit here is what we call here at Dimensional, the fund landscape. The mutual fund landscape. No, it is the fun landscape. Fund landscape. It's got a D on the, I mean it is fun. There's a lot of great graphics in it, but it's fun, duh. Fund landscape. On that point though, it is, you said mutual fund, and we used to do the mutual fund landscape, but I love the fact of the work that you've done, pulling in a lot of the ETF stuff, and you see similar results. Yep, so we've expanded it to the fund landscape, mutual funds, and ETFs. And that goes back to several years ago we started this, just to see how our managers doing relative to their benchmarks. So maybe give us an overview of the fund landscape, how we go approaching that in assessing managers. Yeah, and like you mentioned, we've been doing this for more than a decade now. So we originally set out to look through the data to see, we have a belief about the power of markets, and how competitive it is, how challenging it is to outguess markets. Well, that should imply that you shouldn't see widespread evidence of managers being able to outperform benchmarks. You would probably expect a paucity of funds that are able to outperform. And sure enough, that shows up in the data, when you look over 10, 15, 20 year horizons, very few are able to outperform perspectives' benchmarks. But even beyond that, I think one of the things that surprised me, and you made a good point earlier, when you talked about the connection between the mutual funds and ETFs, where we see some of the same outcomes, was the lack of survivorship. How many funds were around? I mean just in the equity space alone, you had 2,800 funds, or even more that were around 20 years ago, and less than half of 'em are still around today. And so you think about, okay, yes, underperformance is probably a big part of that, but there's other characteristics that we know that can drive investment outcomes that can kill these funds over time. I think it's a good point. I mean, a lot of times, when we're out talking to financial professionals, that's one of the points we really hammer on is this idea of the survivorship. 'Cause you're right, the performance is one part of it. But from a financial planning standpoint too, I mean if you have more than half of the funds that are closing down, that's problematic for you. It's a good point to make about what that survivorship means, because if you're trying to assess what is a possibility of me picking a outperforming manager going forward, the relevant opportunities that are the relevant sample to assess was what was available say 20 years ago. It's not funds around today that have been around for 20 years, because you're gonna have potential bias built in, what we sometimes call survivorship bias, where the fact that they were around that whole time probably means they were on sort of the right side of the return distribution, or had performed better than the average fund, which is why they lasted that long. And so I think that's one of the challenges for investors. Well also I think you bring up the challenge that even if you're on the right side of that distribution, it's a question of is it true manager skill? Or is there some luck that's involved? And I think we can get into some of that, that you've seen that over time, where you get some long runs of really good manager performance, but then sometimes those managers that did really well can almost turn on a dime and have horrible performance. So then it's a question of, did they somehow lose their skill? Or was maybe the first run a little bit of luck that was baked into that? Well, in the document we're going to allude to here, The Fund Landscape, the audience out there can go find this, it's publicly available, just search Dimensional Fund Landscape, and you'll be able to get access to some of the numbers we're gonna be mentioning. But Jake, go back to your comment there about sort of this desire to go find the best managers. It seems to be always there as an investor. And I say always there, meaning going back for decades, that that's what you did. You find the smartest, the most well-educated, the hardest working, and somehow that should translate into success. And by success, my ability as a manager to outperform my respective benchmark. But I think one of the first studies ever done in evaluating manager performance was back in the 1960s, with Michael Jensen. And I think those results, you saw a pretty large number of managers underperform their benchmarks. Yet, that quest kind of keeps continuing and continuing for decades. Well, I love the fact you brought up Michael Jensen, and that really I think the first big study on mutual funds. And what's funny is if you go back a little bit before that, you didn't even know how well your manager was doing. 'Cause we didn't even have any data, right? We had nothing to even analyze. No computers! Which is wild to think about, right? But then we get some data, we're understanding this, we're looking at manager performance. And you're right, back in the '60s, we realized that most of these managers didn't perform as well as the market. So it does kind of bring up the question of, we've seen this through the decades, we've seen continued manager underperformance. Why does the idea of stock-picking, timing markets, trying to outbeat markets through mispricings continue to persist? And I think it's part of human nature. I mean in every other aspect of your life, really, the harder you work, the smarter you are, the better you can do. And when you go to investing, more often than not, it's really the opposite, and can almost get you in more trouble. But I think that's the challenge is extricating how much of that was by chance alone? Which we know that's gonna be a pretty large range of outcomes, versus actual skill. There was another great paper, not quite as far back as the Jensen one, but probably more than 15 years ago at this point, from Fama and French, where their big contribution was actually simulating what the luck-only distribution would look like. If you took skill away from all these managers, it's basically coin-flipping exercise. How big is the range of outcomes? And then once you have that, you can assess how the actual distribution of fund returns look. And it was interesting that it looked very similar to the by-chance distribution, but just shifted to the left, worse, really, by the fees and expenses. And so that, combined with the fact that you might hear a great story from this manager on why they outperformed, I think that story is very compelling. But as we see in the data continuously, that doesn't mean that they're gonna continue to outperform going forward. Love the fact you said their story may be compelling. And I think on previous episodes, we've said this, but a lot of this industry is almost more of a marketing industry than an investment industry. And you come up with a good story, you package it well, you market the heck out of it. Yeah, what can be sold, rather than what's in the best interest of an investor. That's right. But let's dive into the data here. You mentioned 20 years in assessing managers. What are some of the results you found? What percentage of managers beat their benchmark for stocks and bonds? Yeah, it was not many. So if we go back 20 years ago, so you got a little bit over 2,800 equity funds, you got a little bit over 1,600 fixed income funds. And then the survivorship rates in both cases were a little bit less than 50%. So I mean, more than 50% of these funds are dropping out, either through a liquidation. Sometimes people ask what happens to these funds? They can either be liquidated, where it's returning capital to investors, or merged with another strategy. Frankly, I'm not sure the merger is that much better, because it could be the case that fund gets merged with another investment style, or a different style of the management process, maybe goes from fundamental investing to pure quant. So in that case you might get something you didn't really plan to sign up for. And you can go beyond that. I mean you have 18% of the equity funds that started that 20-year period both survive, and beat their perspectives benchmarks, 16% for fixed income. So the deck is stacked against you, right? And I think that's to the point of the power of markets. Well, and also I love the fact you brought up fixed. 'Cause a lot of times people focus on the equity, they focus on the stock side. That's some of the numbers we're quoting there. But you look at the fixed income markets, there's a ton of trading that's going on there. There's a lot of information in prices and the idea of identifying mispriced bonds, predicting where interest rates are gonna go, all of these sort of same things, it shows up in the fixed income markets as well. It's really hard if you take this approach to outperform your benchmark. All right, so let me look at those results and say whether it's 18% of stock managers, only 18% beat their benchmark. But as an investor, you might say, "Well, what do I care? I'm not buying," I'm not in the 18%. I'm not buying the 18%. Yeah, exactly. Bad managers, I'm just gonna buy the 18%. They're the good managers. So how do you guys think about just going after that strategy? Just buy the winners. Yeah, and that's what I would do, based on my own inclination. But the team runs a related experiment which is looking at the persistence. And so they rank all of these funds within their Morningstar categories, accounting for the investment objective, ranks them into quartiles, looks over consecutive five-year periods and says, "Of the ones that were in the top quartile in the first five-year period, how many of them stay in the top quartile in the second five-year period?" So it's interesting when we look at this experiment that the average rate of remaining in the top quartile is a little bit less than 25, it's 23% in the data through 2024. So again, this is exactly what we would expect out of a competitive market, and I think it just illustrates the challenge of using prior returns to evaluate managers. But I do think that's something that a lot of investors take as an approach is, I just go buy the ones that have done well, but you're just telling me it's truly a coin flip. Some will do well, some will do poorly going forward. You just have no idea. And there's really no evidence to suggest which one will continue to do well, and which ones will do poorly. Yeah. After the fact. Well I think it's indicative of how, we're talking about in the case of one fund's track record. And this is why when you're looking at prior returns, you wanna have a little more nuance to it because let's say I look across managers' suite of offerings and they span different investment categories in US small value emerging markets, fixed income. And if they have a wide body of work of outperforming benchmarks across all those categories, that's indicative of a process. Unlike having a star manager, a process is repeatable. And that means you might expect some of that performance in the future. Not a guarantee, but a much better indicator than one fund's track record. It's a little bit of key person risk too. I mean, if you're in this one fund, and for whatever reason over a short period of time it's going well and either they change up their strategy, the person goes on to something else. I mean, anytime you've got key man risk versus a process based approach, you're probably gonna be better off over time. And I love what you said across an entire suite of solutions at a manager versus just one sleeve, maybe one portfolio manager. Well there are a couple characteristics or maybe criteria you can look at for a respective fund that gives you some indication of subsequent performance. And Jake, walk us through some of those. I mean, fees is a big one where the fees align with performance in the data, in the fund landscape. Well I love that in the fund landscape that we've looked at, right? 'Cause we'll basically take all of these managers that you cited here, sort of everything that's available to a US investor, we'll break it up into quartiles, and we'll say sort of what's the median expense ratio of low, all the way up to high, which I think by the way, it's right around 80 or 81 bps for the median of the low quartile, which is we always joke is not low, it just happens to be the median. And that is over a 20-year time period. And that is over a 20-year time period. But you see it when you look at sort of percent that outperform their benchmark, and percent that underperform their benchmark. When you go from low to high, you see more outperform in low and less outperform in high and there's nothing special that's going on there, except for there's only one spot where that money comes from and it's the return that investors take home. Yeah, you're building in a headwind for yourself. Yeah. It's like anything else we do in life, where the more our costs are upfront, the more of a hurdle we have to get over to really find a net profit from it. So I think that's, it's really interesting, when we look at the performance, the rate of outperformance, conditional on the ranking on fee quartiles, you do see a monotonic drop off in the rate of outperformance as you go from the low to high side. So it's, when you think about, okay, what can I make sense of out of the fund landscape? Well one thing you look at is what characteristics are associated with different levels of underperformance and certainly fees are one of 'em. And those are published. And by fees we're talking about the expense ratio, in this case. But there's also another set of costs that aren't necessarily published, which gets into the trading costs and the magnitude of those. One way to measure that is looking at the turnover of a fund. How much are they buying and selling on any given year? And we see a similar relationship on turnover to fund performance as well. Yeah, it looks very similar to the, when we rank on fees, the higher the turnover is, and that's like you mentioned a proxy for the trading costs they're gonna be incurring, the lower the rates of outperformance. And again, it's another way to think about what are the costs you're embedding is a hurdle that you have to clear, even before you can at least match the benchmark. The other thing too, which we, and we don't have time to get into today, but we have done some episodes on sort of taxes and distributions and those type of things too. Like you gotta be careful, are you looking sort of pre-tax? Or are you looking after tax as well? Because when you've got a lot of trading that's going on there, maybe you're not thinking about tax efficiency. Now what you really walk home with as an investor can be even lower. Yeah, absolutely. I'm gonna give a couple numbers here just to give context to turnover, so people know what we're talking about here. So turnover, and here, I'm just going to keep it short here and just talk about some of the stock funds. But on that first quartile, the median turnover rate over 20 years was 25% turnover over the fourth quartile. The highest, the median was 125%. 125% says you have bought and sold everything within that year and more than that. Oh, on average security is staying in that portfolio for less than a year. That's pretty high turnover. Yeah. And then the 25% says I'm selling a quarter of my funds. So you might hold something on average four years. Okay. Just wanted to give some context too, when we're talking about high and low turnover, what those numbers might mean. I think it's an interesting commentary when we talk about all these aspects of costs. One reaction investors might have when they look at the paucity of active funds that are able to outperform is why even play this game? I'll just go find the cheapest thing possible. Well there's issues with that as well. Well there's a lot of issues with it. I mean this is really, we talked about sort of you got the traditional active management, we talked about computers coming on scene, we run some of the first studies, then you start to have sort of the conversations in the late '60s, '70s, around indexing. And this is really the birth of index. And we've seen it grow in popularity. But I think what Wes is bringing up is, is that this idea of, well if these managers can't do it, let's just go buy the lowest cost option. As we say, be careful on that, because I hear all the time, well, indexing is low cost. It's like whoa, whoa, whoa. It's low fee in terms of the expense ratio. It may not actually be low cost, when you really understand all the cost of implementation and what you might be giving up. It gets back to me, the philosophy of the manager, right, is the goal. The philosophy for an index fund says, "Hey, I'm not even gonna try to beat its benchmark. I will try to represent that pre-cost," but then after cost, you're probably gonna be underperforming the benchmark, or an active manager. Their goal is to outperform the benchmark through identifying mispricing, which I liked how you said that earlier. We just went through the results. Results are incredibly low though for that goal. But let me read a couple headlines here. Kind of going back to the philosophy of a manager then, and your point about the indexing. So one headline here, "The hidden cost of passive investing." Which a lot of people call indexing. And then the second one, "Active management's persistent failure," as it applies to performance. So we've already addressed the active manager one there, but just expand a little bit more on some of the challenges that an indexer has. Index manager. We talk a lot about this here around here at Dimensional this idea of reconstitution, sort of like the index is gonna determine what goes in, the index is gonna determine what goes out. The manager's job is to track that by the same stuff at the same time, same quantities at the index, right? And the problem with that is, is that when you have very little flexibility and you gotta basically buy, you're forced to buy and sell certain stocks, you may not get the best price, and that shows up into the returns that you actually walk away with as an investor. And it's not unlike if I have a traditional active manager who thinks that they found something the rest of the market is not onto, and they gotta get their trades in immediately to make sure that information doesn't get leaked out before they take advantage of it. Well, it's a similar set of binding constraints around index fund investing potentially, where if you're an index fund manager, you're buying and selling based on whatever the changes are to the indices in accordance with the index providers. So again, that can lead to higher cost per unit of turnover. So in that case, low turnover actually might not be low cost. But to your point, when you have a lot of people who are buying and selling these securities simultaneously, we could be pushing prices in a way that it's not gonna show up as a cost, it's not in the expense ratio, it's in the actual returns of the indices. And so even if you're an index fund manager who's nailing exactly what the benchmark is doing with zero tracking error, you still built in a downward pressure in terms of the returns. Well, and if you get into the details too, it's also do you really wanna hold every single thing that might happen to be in the index? Or are there some stocks or bonds within there that as you understand the research, you understand sort of where you have higher or lower expected returns, you can make some adjustments to the portfolio that might help you do a little bit better over time. All right, so let's go back to the subject of this particular episode, Assessing Manager Performance. Some key takeaways for me on the conversation. It's incredibly difficult to outperform the market over long periods of time, for the reasons we talked about there. There are some things as an investor you wanna be sure of when you're considering different funds, mutual funds or ETFs. Obviously the expense ratio is important. Understanding of what that turnover historically has been for that particular fund is incredibly important as well. And know the manager's philosophy. And so I would encourage anybody listening out there to do a search on Dimensional Fund Landscape, and you can get the document that we're referring to here and see some of those numbers in greater detail. Anything else you guys wanna add to that conversation? Nope. Love it. Good job. All good? All right. With that, everybody, thank you for joining us today. And as we round out 2025, the next episode is gonna focus on some of the headlines as we go into the new year in 2026. Thanks for joining, and have a great day.