May 21, 2023

Whether active managers consistently outperform their benchmark or not is an empirical issue that must be resolved by looking at their performance data. The SPIVA scorecard published by Standard & Poor’s reports the percentage of managers underperforming their benchmark. The report shows jointly these results suggest that in any of these categories, for a person selecting and staying with the same active manager, that active manager is likely to underperform its benchmark. Given that the actively managed funds have a higher management fee than the passively managed index funds, the SPIVA results raise a simple question: Why pay a higher fee to underperform in the long run? Score one for the passive strategy. But does the SPIVA data conclusively prove the case of favoring a passive investment management strategy over an active management strategy? Is the case for a passive strategy as strong as this SPIVA data appears to suggest? In the next few paragraphs, we examine and interpret much of the SPIVA data. We argue that the passive case is not as strong as it appears to be. Economic disturbances generate size cycles that cause changes in the dispersion of returns and thereby altering the opportunity set of stocks likely to outperform their index. The popularity of cap-weighted equity indices opens the door to explore and develop active and cyclical size related strategies. The reason being that cap weighted indices automatically increase their exposure to stocks whose prices appreciate and reduce their exposure to stocks whose prices fall. As a result, one can argue that cap-weighting tends to overweight overvalued securities and underweight undervalued ones. This provides an opening for active portfolio managers. Instead of accessing this market exposure via traditional cap-weighting, an active manager would use an alternative-weighting, or construct portfolios that differ from the index or benchmark in order to increase the portfolio exposure towards certain factors, such as size and style. In theory, many of the portfolio built by the active managers preserve the typical benefits of traditional capitalization based such as broad market exposure, diversification, and liquidity. The previous paragraph also raise an interesting issue. The discussion suggests that the definition of skilled investors as is commonly used is too narrow, it focuses solely on the investor’s ability to select stocks that outperform their index or benchmark. But as the saying goes, there is more than one way to skin a cat. There is more than one way to deliver superior returns relative to the benchmark. A top-heavy cap weighted index combined with a changing economic environment that generates size cycles provides the necessary elements to implement a cyclical strategy that takes advantage of the changing odds of outperforming an index that is neither random nor reflective of a stock selection skill.

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