He cites several studies and some of his own tests that demonstrate the futility of seeking alpha. Among the findings, a single actively managed fund has a 42% chance of beating a comparable index fund over the course of a single year, a success rate that drops to 12% over 25 years. The statistics get much worse as you add more active funds. If you own ten funds, you have a 27% chance of beating an all index fund portfolio over one year and a mere 1% chance over 25 years.
Ferri’s own work analyzed the returns of actively managed funds within a generic asset class over five years. He found that a portfolio of five randomly selected active funds had only a 16% chance of beating an index fund, that only 5% of them won by 0.5% or more, and that 63% of them lost by 0.5% or more. When the portfolio was expanded to ten active funds, the numbers were much worse. Only 8% were winning portfolios, 1% of them won by 0.5% or more, and 70% lost by 0.5% or more. Ferri then massaged his model to see whether the numbers could be significantly improved; they couldn’t. As he summarized the results, “Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!” (p. 92) (more…)