July 2024
IN THIS ISSUE
Leading or lagging?
Upsets happen
On March 17th, 2023 the 16th seeded Fairleigh Dickinson Knights made history by upsetting the 1st seeded Purdue Boilermakers in the first round of the March Madness NCAA Basketball Tournament. The following year Fairleigh Dickinson failed to make the 2024 March Madness entirely, in their most recent March Madness Tournament appearance in 2019 they lost to the 1st seeded Gonzaga Bulldogs in a lopsided affair 87-49, and excluding play-in games they had never won a regular tournament game in school history. Purdue redeemed themselves in 2024 by making it to the March Madness championship game, losing narrowly to UConn for the national championship.
On April 7th, 2007 Matt Serra shocked the Mixed Martial Arts world by upsetting the Welterweight Champion Georges St-Pierre, who was pegged at a whopping -1100 underdog prior to the fight. St-Pierre’s 26-2 career record and complete domination of the Welterweight division over his 15 year career has made him arguably the greatest MMA fighter of all time. In the rematch one year later St-Pierre dominated Serra over 2 rounds before the TKO stoppage, with St-Pierre landing 42 significant strikes to Serra’s 3. Serra’s career ended 3 fights later with a career record of 11-7, and notably is not on most greatest MMA fighter of all time lists.
Upsets happen. They are exciting when they happen! But it’s Likely unwise to bet on those upsets recurring in the future. The best basketball programs, and the most skilled fighters, will win more in the long run.
Imagine analysts picking teams like Fairleigh Dickinson each year, or picking fighters like Matt Serra in each fight. Those analysts might occasionally get to claim insight in calling a rare upset, but more often than not they will look foolish, lose credibility, and eventually lose their jobs.
Now imagine investing pundits calling for upsets every year. That’s what most traditional active managers do when confidently asserting their purported skill in outperforming the S&P 500 Index.
Famously, Dave Ramsey advocates for actively managed mutual funds versus passively managed index funds, and periodically gets challenged by listeners about the long term underperforming track record of active managers:
In a lively segment of the Ramsey Show, 21-year-old caller Matt sparked a spirited debate on the merits of index funds versus mutual funds. Matt, who has been investing since he was 15, called in to ask why the show’s hosts, known for their financial advice, prefer mutual funds over index funds.
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"The perks of index funds include diversification, low expense ratios, and predictability. However, your index funds won’t beat the market since they represent the market." He added that the goal of mutual funds is to outperform the market, though this isn’t always a guarantee.
Matt challenged this by stating that 80% of mutual funds don’t beat the market over long periods. Kamel countered with recent data, "Morningstar reported that nearly 57% of actively managed U.S. equity funds beat the average index fund peer over the 12 months through June 2023. So, six out of 10 mutual funds beat the index."
Ok, did you catch that? Matt cited a statistic that 80% of mutual funds underperform market indices over long periods, then in reply host George Kamel cited a statistic that active funds beat their indices for one year. Upset.
Kamel’s statistic comes from Morningstar’s recent report Actively Managed Funds Surprise in Market Rebound:
Over the 12 months through June 2023, 57% of actively managed funds survived and beat their average passive peer, their highest success rate in years. Active strategies normally trail passive index rivals during market rallies, but strong security selection and some wobbly index returns set the stage for an unexpected active-fund renaissance.
One year isn’t a sufficient time horizon from which to draw conclusions. Success rates can fluctuate wildly from year to year, depending on what’s going on in the markets and how that uniquely affects the active and passive funds we compare.
Longer horizons provide stronger signals that investors can incorporate into their selection processes. In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons. Just one out of every four active funds topped the average of passive rivals over the 10-year period ended June 2023.
The upset is clear. Active managers have occasionally outperformed passive indexing, but over long time horizons active managers underperform passive indexing.
Thinking in Likelyhoods, which strategy will perform better for investors over long time horizons? The data clearly supports passively managed index funds, as readers of Likelyhoods know very very very well.
Of course some attention-seeking pundits ("Dr. Doom" Nouriel Roubini, Robert Kiyosaki, Michael Burry) seek to call rare upsets that thereafter can lead to career-defining fund inflows and media attention. But more often than not, betting on upsets leads to one-hit-wonders and long term underperformance - just ask Fairleigh Dickinson and Matt Serra.
ONE MORE THING…
Leading or lagging? When two popular recession indicators failed 👎 Calling recessions is very difficult, not least of which is because in complex market environments indicators can be leading, or lagging, or just wrong. See also - Likelyhoods: Indicators: Leading or Lagging?
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