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Yes, There Are Good Active Funds

The average active fund is a loser. So, don’t buy the average active fund.

Dan Culloton, 02/12/2013

Statistical portraits of the average American are often unflattering. The numbers usually describe the typical Yank as an overweight coach potato who consumes too many Quarter Pounders and sugary drinks. “Basically,” my daughter quipped after reading such a description, “the average American is gross.”

It’s easy to come to a similar conclusion about active money managers. Studies by Morningstar and others of the performance of the typical actively managed fund versus relevant benchmarks often show the active fund losing. The theories explaining indexing’s advantage are well known. Because professional managers make up most of the market, on average, they can’t beat the market, on average, after they deduct their fees. So, low-cost indexing is bound to beat the typical active manager. Even the managers who manage to beat their bogies in one time period will find it darn near impossible to do so in subsequent time spans.

This has not gone unnoticed. In recent years, investors have pulled hundreds of billions of dollars from actively managed domestic stock funds and poured a comparable sum into traditional and exchange-traded passive funds. To the extent that the cash has gone toward building balanced portfolios of cheap, broadly diversified stock and bond index funds, it has been smart money.

A Hopeless Case?
Yet, even indexing adherents disagree whether passive investing is an all-or-nothing proposition. Last year, I attended an event held in honor of Vanguard founder Jack Bogle by the Institute for The Fiduciary Standard in New York. Naturally, indexing was one of the main topics of discussion. Roger Ibbotson, the Yale professor and founder of Ibbotson Associates; Burton Malkiel, author of A Random Walk Down Wall Street; Gus Sauter, Vanguard’s outgoing CIO and former index fund manager; and even David Swensen, Yale’s very active endowment manager, all agreed on indexing’s central tenets and attractions.

The only issue on which they differed was whether indexing, which now accounts for about one fourth of mutual fund and ETF assets, should completely dominate investors’ portfolios. That’s when a difference emerged, and I thought about my child’s revulsion of the average American.

Sauter, the veteran index fund manager from the firm that did for passive investing what McDonald’s did for the hamburger, actually conceded that active management was not a hopeless case. It’s possible for some active managers to beat the market, Sauter said, though it’s so hard to pick them beforehand that investors should still index a big portion of their assets just in case.

Swensen, the highly active endowment manager whose success and writings have inspired a generation of institutional investors to add alternative strategies and asset classes to their portfolios, said it was either all or nothing when it came to active and passive investing. If you can’t bring the same kind of time, expertise, and resources Yale does to bear on the task of selecting managers, don’t bother, he said. Just index everything. “There’s almost no chance that you’re going to pick an active fund that’s going to beat the market over a 20-year period,” he said.

Bad Managers vs. Bad Behavior
Even if you are a self-possessed investor, is it worth the bother looking for consistently above-average managers? Arguments against active management often rest on studies that pit the returns of the average manager against a specific index or series of benchmarks, such as the S&P 500 or its growth, value, and market-cap cousins. These studies have encouraged the exodus to passive vehicles but also have shortcomings. Some benchmarks aren’t a good fit for the funds in the categories they try to represent, and the fees and transaction costs that drag on active managers’ results don’t hinder the benchmarks.

To circumvent some of these problems, I looked at the performance of actively managed domestic-stock funds versus relevant passive alternatives that charge fees and incur trading costs—in other words, indexes that investors could actually buy. I compared the return of the average actively managed fund in each category with that of the average index fund in each peer group.

Most investors, however, don’t want to hire the average active manager; they use some criterion to find who they believe will be above-average managers. I also looked at the average actively managed Morningstar 500 U.S. stock fund in each category versus its typical passive rival. The Morningstar 500 is a reasonable proxy of what’s left over after an investor applies rudimentary screens to the entire fund universe. It’s not exactly the image of the typical above-average fund, but it sifts out most of the dross.

The results, as of Sept. 30, weren’t much different from other active/passive scorecards: The index funds won in most categories and time periods. The typical active U.S. equity fund lagged the average index fund by about 1% in its peer group in most of the nine squares of the Morningstar Style Box for the trailing one-, three-, five-, and 10-year periods through the end of the third quarter of 2012. Active funds won in no more than three of the boxes in any one period, though active mid-value funds edged their index counterparts in every time period and small-value active funds won in the three-, five-, and 10-year periods.

Here are two theories on why mid- and small-value managers fared well. Much of the past decade favored smaller-value stocks, which were relatively out of favor in the late 1990s. Also, many actively managed funds that don’t limit themselves to mid-value stocks, such as Delafield DEFIX and FPA Capital FPPTX, end up in the category because, on average, the portfolios produced by their flexible strategies map to the mid-value style box area. Still, some stricter actively managed mid-value funds, such as T. Rowe Price Mid-Cap Value TRMCX and Perkins Mid Cap Value JMCVX, also have done well.

Such funds helped the average active Morningstar 500 U.S. equity fund do better than the broader active manager average against the typical index fund over the past decade. In the 10-year period ended Sept. 30, the typical actively managed Morningstar 500 U.S. stock fund dominated. It beat the average index fund in eight of nine style box categories. Passive funds prevailed only in large growth over this period. The average actively managed Morningstar 500 domestic-stock fund struggled over shorter periods. In the categories and time periods in which it lagged, the typical Morningstar 500 fund trailed by 1.3%, a bit more than the broader active fund average.

This snapshot of past performance doesn’t predict future results, but it shows why investors have flocked to passive investing vehicles in recent years. There is, however, some hope for active managers in the 10-year performance of the average Morningstar 500 active domestic-stock fund. It lends some credence to the contention that, while it can be challenging to pick actively managed funds that beat rival index funds, following reasonable selection criteria and exercising patience can improve your odds of beating the indexes over the long term.

Patience is vital. There are many actively managed funds that have beaten their indexes over the 10-year period but have lagged, sometimes by considerable margins, in one or more of the shorter periods. Achieving long-term success with funds like Dodge & Cox Stock DODGX and Diamond Hill Small Cap DHSCX requires enduring fallow periods.

Don’t Settle for Average
If you bought and held an appropriate mix of index funds, you’d help your odds of avoiding self-destructive behavior and reaching your investment goals. You need not be doomed, however, if you did the same thing with a set of low-cost, competently managed active funds, which despite Swensen’s blanket dismissal, do exist. The average actively managed mutual fund, like the average American, can look pretty gross. It charges higher fees than passive funds for subpar returns with more volatility and tax headaches. But just as not every American is an obese, soft-drink swilling couch potato, not every actively managed fund is a bloated, risky, shareholder-gouging mediocrity.

You can increase your odds of success, though by no means guarantee it, by setting very high standards for selecting actively managed funds and sticking with them. Morningstar analysts have long done so, first with our Fund Analyst Picks and now with our new qualitative Analyst Ratings, which both focus on funds with experienced managers, proven strategies, responsible parent companies, reasonable fees, and long track records of success. We call these criteria the five Ps: People, Process, Parent, Price, and Performance. Our studies have shown that our Fund Analyst Picks have done well over time, and we’re confident it will also hold true for the Analyst Ratings, which have supplanted the picks.

Don’t take our word for it, however. Indexing’s greatest evangelist, Bogle himself, delineated similar standards for selecting successful active managers in the inaugural 1985 annual report of Vanguard Primecap VPMCX. In it, Bogle said Vanguard hired Primecap because of its people, philosophy, portfolio, and performance. Those criteria have been the basis for Vanguard’s approach to selecting subadvisors for actively managed funds for years.

It’s tough to beat low-cost index funds. But just as it was wrong to deride passive investing as settling for average results, it’s a mistake to equate all active funds with the average active fund.


Dan Culloton is an associate director of fund analysis for Morningstar and editor of Morningstar's Vanguard Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. Click here for a free issue of the Vanguard Fund Family Report.

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