Rick Ferri and Alex Benke recently collaborated on an interesting white paper called A Case for Index Fund Portfolios, which I introduced in my previous post. They compared index portfolios to thousands of randomly generated active portfolios to estimate the probability of outperformance. Passive came out ahead in about 80% to 90% of the trials, which is compelling enough. But there were some surprises, too. Let’s look at a few of them.

Indexing gets better with age

Ferri and Benke’s paper was novel in that it looked at portfolios rather than individual funds. They found that combining index funds led to greater outperformance than you would expect from examining the funds in isolation. In other words, the portfolios were greater than the sum of their parts. The authors called these factors Passive Portfolio Multipliers, or PPMs

One of these PPMs highlights the importance of taking a long-term view. Ferri and Benke looked at the five-year periods ending in 2002, 2007 and 2012. The first of those periods includes the dot-com bubble, while the last includes the worst market crash since the Great Depression. Not surprisingly, index funds did a little worse than might be expected during the bear markets, since active mangers could get defensive and move to cash or overweight bonds. The middle period was a strong bull market, the worst environment for active managers, who find it hard to keep up as the indexes charge ahead. Here’s the winning percentage for the index portfolios in each period:

Period Index % Win
1998–2002 66.1%
2003–2007 85.8%
2008–2012 77.5%
Average of above periods 76.5%
1998–2012 (all 15 years) 83.4%

Now the surprise. The average winning percentage for the three five-year periods is 76.5%, but over all 15 years it was much higher at 83.4%. “We concluded that the longer an index fund portfolio is held, the better its performance becomes relative to an all actively managed portfolio,” Ferri and Benke write.

Too many cooks

Look at the portfolios of many active advisors and you’ll probably be shocked to see how many funds are included. Who needs a total-market index fund when you can have two or three different active funds for each asset class? Advisors often call this “strategy diversification,” but Ferri and Benke’s findings suggest it’s worse than useless: it actually lowers your odds of market-beating performance.

The authors ran three trials using one, two and three active funds for each asset class and compared the success rate to a simple portfolio with one index fund for each category. Here are the results:

Portfolio Index % Win
One active fund per asset class 82.9%
Two active funds per asset class 87.1%
Three active funds per asset class 91.0%

Turns out using more than one manager is more likely to subtract value. “We conclude that while in general diversification of holdings is a good investing practice, diversifying fund managers is not,” write Ferri and Benke.

It’s not just about fees

There was one more surprising result in the white paper. Many people would argue the real problem with active funds is not the strategies per se, but the higher cost of implementing them. Surely low-fee active funds have a greater chance of outperforming index funds?

Ferri and Benke found this to be true, but the advantage was probably less dramatic than you’d guess. They compared portfolios of three, four and 10 index funds to randomly generated active portfolios, but this time they included only the active funds with lower-than-average MERs:

Index  Median Median
Portfolio % Win Shortfall Outperformance
3-fund portfolio (1997-2012) 82.9% -1.25% 0.52%
With below-average MER 71.5% -0.92% 0.53%
4-fund portfolio (2003-2012) 89.5% -1.24% 0.39%
With below-average MER 81.3% -1.00% 0.46%
10-fund portfolio (2003-2012) 90.0% -0.93 0.29%
With below-average MER 71.2% -0.57 0.33%

Even by sticking to cheaper-than-average funds, the best you could hope for was a success rate less than 30%. (And let’s remember fund fees in the US are much lower than in Canada.) “A common belief in the investment community is that low-fee actively managed fund portfolios have a meaningfully higher chance for outperforming an all index fund portfolio. We find no evidence to support this view.”