How the world has changed! Once, the professors sided with the indexes and financial advisors with fund managers. Now, a professor writes kindly of portfolio managers--and his article is attacked by an advisor.
The professor is Abhay Kaushik at Radford University, and the article is "Performance and Persistence of Performance of Actively Managed U.S. Funds that Invest in International Equity," published in The Journal of Investing. Kaushik examined actively run international funds for the 20-year time period of 1992-2011, and he concluded what few professors ever conclude: Portfolio managers were worth their pay. Kaushik wrote, "The findings of this research suggest that most of the international funds do outperform their passive benchmarks. The superior risk-adjusted returns of international equity funds support the superior selectivity skills and valued-added features of active management."
Those words weren't likely to warm the hearts of financial advisors who use passively managed funds. Sure enough, a DFA advisor, Larry Swedroe, struck back on CBS Moneywatch. In last week's article "Don't Believe Everything You Read, This Post Excluded" (practitioners are so much better with titles than are academics), Swedroe criticized the paper on several fronts and stated that the superiority of active management does not "appear to be supported by the results."
Kaushik showed actively managed funds to have a modest advantage over the benchmarks, with the fund average for both total returns and risk-adjusted performance (Sharpe ratios) being higher than the benchmark averages in nine out of 13 categories. Many of these categories are quite small, though, and the evidence was split in the two most populous groups, with the funds prevailing in one and the benchmark in the other.
In addition, Kaushik conducted a peculiar test of "persistence of performance," ranking funds within their category by their one-year total returns and then testing to see how the "winners' portfolios" fared against the "losers' portfolios." This one lost me. Nobody on earth would invest in such a fashion. At any rate, the findings were inconclusive.
In taking on Kaushik, Swedroe committed an own goal. "It's well known that the Morningstar data suffers from survivorship bias. Yet, the author fails to discuss this issue." Say what? Morningstar certainly does retain the records of dead funds, the author used that data, and the paper explicitly mentions the fact: "To avoid any survivorship bias, any fund (active or dead) ..." As I've written before, I sometimes feel that index-fund proponents feel that because they have Truth on their side, they needn't worry about truth. This incident deepens the suspicion.
Neither was I sold by Swedroe's contention that funds can't be fairly compared with the benchmarks because of "style drift." Most international funds are geographically defined. That is, a Europe fund will always be a Europe fund and can reasonably be compared with a Europe index. It's not going anywhere else.
Finally, I didn't understand Swedroe's argument against using the Sharpe ratio to gauge risk-adjusted performance. But that's a detail--by any measure, the actively managed funds fared better than the benchmarks.
Swedroe is correct, though, in questioning the statistical significance of the study and in pointing out that the paper's conclusion is too strong. I agree with Swedroe that the alleged "superior selectivity skills" of active international-stock fund managers are far from proven. They did well in the study, over that particular time period. That's as far as I will go on the matter.
1) The typical actively managed international-stock fund has beaten its relevant index over the past 20 years, albeit not by much;
2) That's better than domestic-stock funds have done, especially large-company domestic-stock funds;
3) If you are to invest actively in large-company stocks, doing so with international funds seems to make more sense than doing so with a U.S. stock fund.
Following the Money
Another way of looking at the matter is from the investor perspective. The academic study looks at portfolio managers rather than investors; that is, it measures how the typical investment manager fared. That is a legitimate, useful approach. However, it's also worth asking if investors were well served by owning actively managed funds or if they would have been better off had they indexed. For that task, we need to look at the largest funds of the time.
In 1992, most international-fund monies were in world funds--funds that invested across the globe, including in the United States. There were no world index mutual funds to be purchased at the time, which was just as well because the biggest world-stock funds (which accounted for most of the industry assets) whupped the index.
- source: Morningstar Analysts
The next biggest category was in foreign-stock funds, which invested everywhere but in the United States. These funds also reliably beat the index**, although here the margins were closer.
- source: Morningstar Analysts
** The MSCI ACWI ex-USA Index is a better fit for the foreign-stock funds than is the MSCI EAFE, but I can't get my hands on that index's performance for that time period.
Finally, there were two large Europe funds, one of which beat the MSCI Europe Index over the next two decades and one of which trailed before being liquidated.
A clear victory for actively managed funds. Make of it what you will.
Oh, and a final note: Although most index international funds have had middle-of-the-pack performance over the past 10 years, Swedroe's DFA funds have been across-the-board winners. Part of this is because they tend to own smaller companies than other funds, which has served them well. However, that is not the entire reason for their relative success.
Thus, although I disagree with most of Swedroe's argument in this particular instance and think he--as with other index supporters--overstates his case, I must salute the results of the funds that he uses. His clients have done well by DFA's international funds, very well indeed.
Ironically, however, DFA's offerings are not index funds, per the firm's own definition. DFA now maintains that, despite outward appearances, it is an active manager. Go figure.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.