A newly published study1 shows that funds constrained to an index can beat the returns of the broader market, and do so more efficiently than stock-picking funds.
The research paper by Professors Alan D. Crane and Kevin Crotty of Rice University applied returns distributional tests to 237 index funds and 1823 active funds from 1995 to 2013 to determine whether their outperformance is based on skill or pure luck. Index, or passive, funds track benchmarks that may be narrower in scope than the entire market.
The first finding of the distributional tests – based on five different benchmark models and a regression of performance against the broader market’s return – was that passive funds generate alpha. One of those tests resulted in 21% of index funds appearing as skilled, compared with 9% for active funds. In only one of the five tests did the share of skilled active funds surpass that of skilled passive funds.
“Our expectation was that when we would run index funds through these technologies, they would largely show up as not being skilled,” Crotty told PULSE ONLINE in an interview. “And we found the opposite. The tests imply that index fund skill exists and is persistent.”
Index funds also exhibited gross performance persistence, with a 30% likelihood that a fund remains in the same performance quintile from one 5-year period to the next. That compares with about 20% for active funds.
Passive investing growth enables study
The study was enabled by the proliferation in the last two decades of alternative-weighted index funds, often referred to as ‘smart beta,’ which follow specific risk strategies aimed at outperforming traditional capitalization-weighted benchmarks.
The finding that passive funds have ‘skill’ challenges the assumption that actively-managed funds’ edge is generated by their ability to pick stocks and time the market. If index funds outperform the market, that means it is the underlying indices themselves that have alpha, the authors say.
“What we could be thinking of as skill for active funds may actually be just the benchmark they are following,” says Crane in an interview.
“We can’t say for sure that’s the case in the active funds space; we can say pretty surely that that’s what’s going on in the index fund space,” Crane adds. “And the amount of skill that shows up there is pretty close to what we are seeing in the active fund space, where managers have the ability to pick up stocks and do other things.”
The suggestion that skilled active managers owe their outperformance to their index selection, rather than their ability to pick stocks, raises new questions about how to reward them, the researchers added.
Choosing between distribution patterns
A second part of the paper compares the distribution of before-fee returns across both fund groups, to evaluate active managers’ skill, something that may not have been done before. Traditionally, the top active funds tend to compare themselves against the median active or passive fund, showing outperformance.
Here, the finding was equally interesting. In the top 95th percentile group, active funds returned 48 basis points (bps) of alpha per month versus 42 bps for index funds, the analysis finds. When accounting for residual risk, the outperformance disappears. The worst-performing active funds register a significantly weaker performance than the poorest index funds. And around the median, active funds show little if any outperformance relative to the median index fund.
“When performance is measured using before-fee model alphas and compared across the cross-sectional distribution, any active fund performance advantage is substantially less than one would conclude from benchmarking to average index fund performance,” Crane says.
“The spread by which the best index funds outperform the worst ones is a better trade-off than in the active space,” says Crotty. “That leads to the ultimate takeaway: if you couldn’t pick exactly where you are going to be in this distribution, you’d want the index funds.”
Finally, the study also found there is a relationship between performance of passive funds and posterior flows into them, with more money pouring into funds that show larger past gross returns.
To read the paper ‘Passive versus Active Fund Performance: Do Index Funds Have Skill?’ please click here.
1 ‘Passive Versus Active Fund Performance: Do Index Funds Have Skill?’ Journal of Financial and Quantitative Analysis, Vol. 53, No.1, Feb. 2018, pp. 33-64.