You can see why Jack Bogle’s turn of phrase gets under the skin of his detractors. Take, for instance, this famous assertion in The Little Book of Common Sense Investing: Benchmark.
“If the data doesn’t prove that indexing wins, well, the data is wrong.”
When I first started researching the investment industry, I remember reading that statement and finding it rather flippant, churlish even. Yet in the intervening four years I’ve seen many an attempt made to prove Bogle wrong on this point, and none of them succeeded. There is a whole industry — a hugely powerful and wealthy one — that desperately wants to convince us that active management is worth paying for. But it can’t.
It’s not for want of trying. In fact it’ll try almost anything to demonstrate the superiority of active funds. One of the tricks it likes to pull is to compare returns to the wrong benchmark — comparing apples with pears.
People talk about “the benchmark” as if there’s only one. In fact there are scores of benchmarks. Also, some of them are much harder to beat than others and, as new research from the University of Bath demonstrates, the industry always likes to compare returns with benchmarks that are easier to outperform.
When a new fund is launched, a Primary Prospectus Benchmark (PPB) is chosen and used as a comparator when assessing the fund’s performance. So, for example, a fund that invests in large UK companies is typically compared to the FTSE 100 Share Index.
The problem is that there are very few funds that exclusively invest in securities in just one index. Typically, for example, a fund that invests mainly in UK large-caps will also invest mid-caps and/ or small-caps. As evidence-based investors know, small-cap stocks tend to deliver higher returns over the long term, albeit with a higher level of volatility, so you would expect a fund that invests in both larger and smaller companies to outperform a fund that just invests in blue-chip companies.
Similarly, UK equity funds also diversify into emerging market stocks; the rules allow managers to invest up to 20% of the money it manages in assets other than UK equity. Again, EM stocks, although riskier, deliver higher returns over the longer term, so you it’s no surprise that a fund with exposure to emerging markets will generally beat a fund that purely invests in UK equities.
The research on over 4,500 personal pension funds operating in the UK, Jumping over a low hurdle: Personal pension fund performance, A team led by Ania Zalewska, Professor of Finance at the University of Bath School of Management, researched more than 4,500 personal pension funds operating in the UK between 1980 and 2009.
It concluded that when funds appear to beat their benchmarks, it owes less to the investment skill of pension managers and more to the selection of benchmarks which are easy to outperform.
The research findings are contained in a report called Jumping over a low hurdle: Personal pension fund performance, and published in the Review of Quantitative Finance and Accounting.
“This study provides convincing evidence that pension funds are reporting their performance in relation to benchmarks which are not reflective of their true investment profile,” Professor Zalewska says. “It creates a spurious impression of good investment skills for consumers who are paying a premium for actively managed funds.”
Alas, it’s a trick that pension fund trustees, journalists and retail investors continue to fall for again and again.
For those of us who want to educate investors and help them to achieve better outcomes, all we can do is keep directing them towards the overwhelming evidence that low-cost index funds — or other passively managed investments — are the logical choice for the vast majority of people.
To quote the Nobel Prize-winning economist William Sharpe, “the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”
Bogle wasn’t being dogmatic. He was simply telling the truth.