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The New Breed of Active Management

Lessons from last year’s sales champions.

John Rekenthaler, 01/20/2017

Changing of the Guard
Through the turn of the century, blue-blood stalwarts like Fidelity (founded 1946), American Funds (1931), and Putnam (1937) consistently dominated fund sales. At times, brokerage firms crashed the party by pushing their proprietary funds, but such incursions were short-lived, because the reputations of their funds quickly caught up with their performances. For the most part, the grande dames held sway.

All that began to change with the New Millennium, as relative newcomer Vanguard muscled into contention. The 2008 market crash accelerated the trend. Since then, the vast majority of traditional firms have faced steady redemptions. This has become Vanguard’s world, which we share only with Valley Forge’s permission. Passive funds dominate, but a few active managers have braved the sales headwind. Below are the five active fund managers who attracted the most net new assets in 2016.

(This list comes from Morningstar data, as requested by trade industry publication Ignites.)

1. Vanguard (Founded 1975, $183 Billion)
Rough justice indeed! The company that displaced active management also leads the current sales charts among active managers. That's not to say Vanguard’s actively run funds account for much of its inflows: For perspective, $257 billion went into the company’s passive funds. But every little bit counts.

Adding to the irony is the reason for Vanguard’s success: Its active funds look a whole lot like index funds: low-cost, low-turnover, and low-surprise. Its stock funds are typically diversified not only across hundreds of stocks, but also across multiple portfolio managers. Its bond funds are active in name but passive in mindset. They look much like their benchmarks and change only slowly.

Even Vanguard’s sector funds are conservatively run. Rival fund companies tout their sector-fund managers’ insights, the ability for professional managers to find what the rest of us cannot. Vanguard, in contrast, has been content with a simpler pledge: Its sector funds will behave as their industries do, reliably and consistently.

2. AQR (Founded 2009, $10 Billion)
Technically, Applied Quantitative Research began operations in 1998, but its first mutual fund arrived a decade later. The company’s name gives the first clue of how it differs from the industry’s founding fathers. AQR’s idea of active management is far removed from the traditional notion of the “prudent man” who carefully vets each portfolio holding. (The language, as with the origins of the fund industry, is exclusively male.) This firm invests by the numbers, as befits an organization co-founded by a trio that met during a finance Ph.D. program.

In a sense, AQR’s funds are active indexes. The company identifies strategies that it believes have investment merit--for example, the risk parity approach of allocating assets so each portfolio sector carries the same amount of risk, or the momentum tactic of buying stocks that have recently performed well. That work is clearly active. But when AQR implements those strategies, it doesn’t monkey around with security selection. It lets the numbers do the work. As such, the portfolio could fairly be called an index of the strategy.

The funds are priced accordingly. AQR Large Cap Momentum Style AMOMX was launched with a modest 0.49% expense ratio for its Institutional share class, which has since declined to 0.40%. Among the industry leaders, only Vanguard and American Funds offer stock funds that are cheaper. Other AQR funds cost more--AQR Managed Futures Strategy AQMIX carries a 1.21% expense ratio, for example--but they nonetheless undersell most rivals.

3. Bridge Builder (Founded 2013, $8 Billion)
The funds are new, but not the company. Bridge Builder is the lineup for Edward Jones, the regional brokerage firm. Offering in-house funds would seem to be a flashback to the 1980s, when Shearson and Lehman each had fund families, as did pretty much every other national broker. And flashing back to the 1980s is no happier an event for mutual funds than it is for workout fashion. The industry was at its worst.

However, Edward Jones’ take on the concept is something entirely different. The Jones funds are reassuringly dull: four U.S. stock funds, an international stock fund, two taxable-bond funds, and a muni-bond fund. Prices are even more reassuring, ranging from a tiny 0.17% for Bridge Builder Core Bond BBTBX to 0.62% for Bridge Builder Small/Mid Cap Value BBVSX. Jones is currently rebating some of those funds’ expenses, so their costs could rise, but they will always be relatively cheap.

That's not the end of the expense tale; these funds are available only through Edward Jones’ advisory accounts, which carry additional fees. Thus, it is not possible to own those funds while paying only their expense ratios. On the flip side, if one does have a Jones advisory account, the Bridge Builder funds are highly competitive. Few outside funds give more for less.

4. Baird (Founded 2000, $8 Billion)
Baird dates back almost a century, as the securities arm of First Wisconsin National Bank, but its mutual funds are relatively recent. It owes its place on this list to two taxable-bond funds: Baird Aggregate Bond BAGIX and Baird Core Plus Bond BCOIX. Continuing this column’s theme, these funds are mainstream, low-cost (0.30% expense ratio for the institutional shares), and constant. Year after year, they deliver what they promise, modestly outgaining other funds in their categories and, on most occasions, also besting the Bloomberg Barclays U.S. Aggregate Bond Index.

Baird’s success, while certainly to its credit, highlights the problems of the rest of the industry. An obscure Milwaukee-based fund family, with little brand name or distribution power, should not be finishing high atop the sales charts because it has two bond funds that beat the competition by about 1 percentage point per year. A lot of other companies have major organizational advantages. But they have not capitalized, and into the breach stepped Baird.

5. DoubleLine (2009, $8 billion)
To an extent, DoubleLine is the exception on this list. Neither its offerings nor its founder are conventional. Whereas the previous four families expect that their funds will raise no questions, if they are properly managed, DoubleLine aims higher. It wants to beat every rival in existence and have the audience marveling at the achievement. This approach has the advantage of generating unusually high returns, as was the case throughout most of flagship DoubleLine Total Return Bond’s DBLTX early existence, but it does increase business risk by raising investor expectations.

That said, the fund echoes the other families’ funds in being reasonably priced--its Institutional shares carry an annual expense ratio of 0.47%--and in not being U.S. stocks. Fund investors still believe, largely, that active managers can outgain their benchmarks with bonds and international stocks. They are skeptical about U.S. stocks. Active management has lost its home base.

Summary
The mutual fund industry was founded on the belief that active investment management was required for stock and balanced portfolios. As time passed, and stocks performed more exuberantly, that expectation has broadened: Fund managers needed to win. They were expected to exert their personalities and to run funds that didn't look like the benchmarks by which they were measured and didn't perform like them, either. The modern fund industry was built on such hopes.

During the past decade, that mindset has shifted. DoubleLine aside, today’s active-management leaders focus more on avoiding mistakes than finding big winners. The game has changed, and the names have changed. Your father’s Oldsmoble still exists--but nobody is buying.

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.

 

is vice president of research for Morningstar.

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