Last update: 17.09.2024 08:35
The return of ETFs vs. active funds is a recurring debate. But the facts are quite clear. Do you know Russian roulette? Would you play it? Discover what the return of ETFs vs. active funds has to do with this game of chance.
What is the aim of active funds?
Funds, whether active or passive, distribute the investors’ money, i.e. the fund assets, among various investments. Active and passive funds differ in the “how” of distribution. In an active fund, a fund manager attempts to achieve a higher return than the fund’s benchmark index by skillfully selecting financial investments. To do this, he and his team must put in the effort and make the right decisions based on the information obtained. They can then buy more shares in one company and fewer shares in another company than are included in the index at the right time. This should result in a composition of fund assets that deviates from the index. After all, the whole purpose of active fund management is to find investments that will outperform the benchmark.
What is the aim of passive funds?
In contrast, ETFs do not claim to achieve an excess return over their benchmark index. They do not want to pick out the best shares or bonds contained in a benchmark index. They stubbornly track their index in the fund assets as closely as possible. Because they do not actively select investments, ETFs are therefore also referred to as passive or passively managed funds. The selection of units, their weighting and tracking of price changes in the fund assets is not done by an expensive fund manager and his analysis team, but by a machine. Of course, this is much cheaper, even if there are cost differences between different products and their performance varies. And: you miss out on the chance of a higher return than the market. In our opinion, this is a perfectly acceptable risk.
But how do passive funds compare to actively managed funds? Does machine beat man or is it the other way around?
Comparison of ETF vs. active fund returns
To do this, we draw on a long data series with systematic analysis. The financial services provider Standard &Poors Dow Jones Indices has been measuring and publishing the returns of ETFs vs. active funds every year since 2002. The SPIVA scorecards(S&PIndices Versus ActiveFunds) are recognized worldwide. They measure the performance of over 10,000 actively managed equity funds against their respective S&P DJI benchmark index. Data is available for periods of 1, 3, 5 and 10 years.
SPIVA examines how many active funds outperform the respective index in the various market segments. Unfortunately, they do not provide any information on which funds these are. We have reviewed and summarized the numerous data for you. So, what do the latest SPIVA scorecards as at the end of 2020 tell us about the returns of passive ETFs vs. active funds? It is clear across all markets that most passive funds are superior to active funds over long investment periods. If you invest in equities worldwide, only 2 out of 100 actively managed funds outperform the benchmark index over 10 years. After just 1 year, the figure is less than half! Another finding: the smaller the investment markets, the greater the chance of outperforming the benchmark over a long period with an active fund.
Finding the right active fund is like playing Russian roulette
Imagine the following game of chance. In front of you are 100 cards with active funds on Swiss equities. Only 16 of them outperform the index over 10 years. You have to choose a card and invest your entire assets in this product. Your chance of picking a good fund is therefore 16%.
Russian roulette is a potentially deadly game of chance. It is played with a revolver whose cylinder can fire six shots, but only one cartridge is inserted. The probability that you will die when you pull the trigger is 16.67%. The chance that you will be hit is therefore 16.6%, which is exactly the same as the probability of choosing the right fund.
Very few of us would take the gamble. But why are there so many people who still buy actively managed funds? The probability of a hit is practically the same.
Why do active funds have poorer long-term returns than ETFs?
The reason for the poorer performance of active funds over longer periods is their high cost. Logically, active fund management costs money. Salaries for the fund management team and performance bonuses, costs for the IT infrastructure, data procurement, reallocations in fund assets and so on.
While ETFs have management fees of 0.1-0.5%, active products have fees of 1-1.5%. This means that an active fund manager has to generate 1% more return per year than the market return – just to compensate for the cost disadvantage. And this feat must be achieved every year!
SPIVA’s data clearly shows that the vast majority of fund managers fail to do this.
What findings are there from studies on the performance of ETFs vs. active funds?
Most active funds achieve lower returns after costs than their benchmark index.
The SPIVA scorecards are just one very well-known study that proves this. This applies to practically all asset classes and market phases. Mathematically, outperformance is not possible in the long term due to the additional costs of active funds compared to passively managed funds, as the Nobel Prize winner Sharpe (2018) has shown. Compared to low-cost passive funds on the same benchmark, active funds perform worse.
What was good yesterday doesn’t have to be good tomorrow.
The best funds in their class are not necessarily top performers in the coming years. This is due to the lack of consistency in the performance of individual funds. There are numerous reasons for this. For example, there may be a change in fund management or investor preferences in the market may change while your fund is tied to its investment strategy (e.g. value, growth). Vanguard (2013) examined the issue of persistence in the study “The Case for Indexing” for active funds licensed for distribution in Switzerland. Only just under 12% of active funds managed to remain in the top performance category (highest performance quintile) in the five-year period under review. The “chance” of slipping into the bottom two performance categories by buying a fund from this category was 56%!
The longer you are invested in an active fund, the more likely it is that you are giving money away.
The SPIVA data series clearly show that benchmarks are superior to most active funds over long periods of time. No matter how much return or distribution you are happy about with your active fund, it could have been more with an ETF or index fund!
The risk of catching a bad active fund is higher than the chance of finding a good active fund.
As only a few active funds beat their index, but many lag behind, you take two risks when you select an active fund for your portfolio. Firstly, you are giving away money, because there is a probability, depending on the holding period, that you will not get the market return. Secondly, the return premium of “good” funds is smaller than the lower return of poor funds.
Summary of ETF vs. active fund returns
Numerous studies show that ETFs are superior to active funds over long holding periods. So if you invest in active funds in your portfolio, you run a high risk of missing out on index returns and giving money away. This is all the more true the higher the proportion of active funds in your overall portfolio. By investing in ETFs, you avoid these risks.
Incidentally, these results apply not only to unrestricted pension provision in pillar 3b, but also to your securities solutions in pillar 3a.
Investing is not about emotions, but about simplicity and returns. That’s why you can trust the ETF machine in fund management, because it beats human management teams in most cases.
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