In August 2000, more than 52 million Americans tuned in to watch the season finale of “Survivor,” the television program where contestants were marooned in faraway locales and pitted against the elements and one another. Indeed the slogan for the show was “Outwit, Outplay, Outlast.” For better or worse, this episode kicked off a 10-year deluge of “reality television” providing the obnoxious and the marginally interesting with their 15 minutes of fame and then some—but it was never truly “reality.”

The investment management industry has its own form of “reality TV.” In this issue we explore the recent impact of the changing composition of peer groups and revisit some of the long festering issues of peer group comparisons. In our view, the manner in which aggregate active manager performance is displayed, vis-à-vis index funds in commonly used peer groups, is not reality.

The S&P 500 In The Bottom Decile Of Active Managers … Really?!?

As we noted in the past few issues of Fundamentals, the S&P 500 Capitalization-Weighted Index lost 1% per annum during the “lost decade” of the 2000s. Ugly. But it gets worse on second glance when we consider the alternatives—active managers. Compared to U.S. large-cap core equity managers, the S&P 500 lands in the 90th percentile—that is, the S&P 500 beat only 10 percent of its large-cap core active rivals for the decade!

Our antennas immediately went up. We are firm believers in Jack Bogle’s “cost matters hypothesis,” which states that, as a group, active managers perform the same as the market less costs.¹ After all, if indexes track the market, then removing the index funds leaves the self-same portfolio, which is the universe held by all manner of active investors. So in aggregate, active manager performance will equal the market, but take out their expensive cost structures and the average active fund must trail the market.

Clearly, the “reality” of peer group comparisons does not align with our views of how the market should work, so we examined the numbers with a bit more joie de vivre.

Batten Down The Hatches And Close Products!

Faced with its most existential crisis ever, the asset management industry responded like “Survivor” contestants dropped on a tropical island. Basic needs ascended to the top of the priority list and, for managers, that meant resources must be concentrated on revenues and profits. Non-essential strategies became a Gucci handbag in the rainforest … almost worthless. Managers began to kill off their “weakest links.”

In 2009, 13% of all large-cap core managers shut down! This followed a dropout rate of 8% in 2008. These figures are well above the typical 5% annual attrition rate of mutual funds (Fung and Hsieh, 2000).² All told, of the 393 managers running large-cap money at the beginning of 2006, 116 (or 30%) are now gone!! One-third of the active managers that investors relied on four years ago have gone the way of the dodo bird.

Active manager peer groups—a reflection of this evolving opportunity set—naturally were impacted by this crisis-induced turnover. As Table 1 shows, the group of non-survivors ranked in the bottom third of the peer group before disappearing. If underperforming strategies were the ones that closed down during the recent crisis, doesn’t this artificially push up the median performance of active managers? With the dead weight gone, the S&P 500—or any indexing strategy—looks less compelling against the “average” large-cap core manager.

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