The S&P 500 Index is a very difficult benchmark for actively managed mutual funds to beat. According to the latest data1, 2020 marked the 11th year in a row the S&P 500 outperformed most U.S. Large-Cap actively managed funds. One reason often cited to use an active manager is “they can go to cash if they feel the market is going to drop.” 2020 had the fastest bear market ever and that still didn’t stop the market from beating most active managers.
The performance comparison of the S&P 500 to actively managed funds throughout history is not kind to the latter. Over the last three years, 69% of the funds underperformed, compared to 75% over the last five years. Over the last 10 and 20 years, 82% and 94% of the funds underperformed respectively, marking an even starker contrast between the performances of the Index and actively managed funds.
Why does this performance discrepancy persist? What if we looked at the S&P 500 Index as a strategy in and of itself? The strategy is simple:
- All the stocks are all headquartered in the United States.
- All the stocks are large in terms of their market capitalization (# shares outstanding X price).
- All the stocks are more than one year old.
- To be included in the index, the sum of the previous four quarters of earnings—as well as the most recent quarter—must be positive.
The stocks must be large, profitable U.S. companies. The stocks remain in the index until they no longer meet the criteria. In other words, large cap stocks that perform poorly over time turn into small cap stocks and are jettisoned from the index. This doesn’t happen very often, as the historical turnover rate of the S&P 500 is only 4.4%, and the Index is rebalanced each quarter.
Why can’t professional money managers beat such a simple strategy?
Fund managers are under constant pressure to beat the market to bring in more assets. To beat the market, their portfolios must be different from the market – in other words, they must try to predict the future and overweight the stocks that will do best in the future. But they don’t have a crystal ball – no one does. Knowing that, it doesn’t make much sense to pay higher fees and receive subpar performance. 2
1SPIVA® U.S. Year-End 2020 Scorecard
2I believed that the underperformance could be explained by the higher fees in the actively managed funds. While the S&P 500 Index ETFs charge an annual fee of 0.03%, the average annual fee charged by an actively-managed fund is closer to 1%. But even comparing performance gross of fees, the S&P 500 beat 68%, 77%, and 84% of U.S. Large-Cap actively managed funds over the last five, 10, and 20 years, respectively.