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How Did Active Funds Handle the First Half?

Or were index funds the place to be?

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Actively managed funds have historically posted underwhelming performance relative to their passively managed counterparts, but was the first-half market volatility any different? Joining me to discuss that topic is Ben Johnson. He's Morningstar's global director of ETF research. Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, you and the team put out this Active/Passive Barometer. Let's talk about what you're trying to measure with this barometer.

Johnson: What we try to measure with the Active/Passive Barometer is active funds' performance as a whole relative to their indexed peers. So, our benchmark, in this case, to judge either success or failure on the part of active managers is actually a composite of all of the different index options that are available to investors, as of the beginning of any given look-back period that we include in this study. So, we add up the performance of say, SPY, the oldest S&P 500 exchange-traded fund that's out there, as well as the Vanguard Total Stock Market Index fund, and so on. And together, those funds' performance becomes the bogy by which we measure active funds' either success or failure. To succeed, by our definition, active funds have to both survive as well as outperform that passive composite over a given period. And we look back in this instance over the course of the first six months of 2020, we look back a year, three years, five years, 10, and even 15 and 20 where data will allow.

Benz: Let's look at that six-month period. You don't typically look at such a short period, but it was very dramatic. We had this huge market sell-off and then a fairly substantial recovery in the second quarter. And one argument that you sometimes hear in favor of active management is that these periods of extreme turbulence, especially the down periods, will be times when active management may be able to distinguish itself and show that it's worth paying extra for. What did you see during this first-half period?

Johnson: This is the first time we've ever included such a short look-back period in this piece because, over shorter periods of time, there's just so much noise that you see in the data. So many things going on with respect to the biases that are inherent in active portfolios, the biases that are inherent in the indexes that underpin passive funds. And it just creates a lot of noise that doesn't yield any real useful information for investors. But in this instance, what we wanted to look at is whether or not that narrative, as you've described it, Christine, that active managers are categorically better suited to add value specifically through protecting investors from market downdrafts.

And what we saw across the 20 categories that we include in this most recent report is that that narrative didn't really hold water. In some, just 51% of all active funds that we included both survived and outperformed their average passive peer through the first six months of this year, which is effectively a coin flip at the end of the day.

Now that said, if you drill down and look more closely at specific groups and in specific categories, those success rates varied pretty dramatically. What we saw is success rates were highest amongst foreign stock funds, they were lowest among active large-cap funds in the stock side of the equation, and in the case of fixed-income funds, they were lower relative to stock funds. Some of the factors driving those trends were, first and foremost--U.S. stock-pickers have had a really tough go of it over the better part of a decade-plus. And most recently, because most of the gains of the U.S. stock market, especially coming out of the very bottom of the market, have been driven by just a small handful of stocks--and pick your acronym du jour, be it, FAANG or FAAMG or FANMAG what have you. It's the Apples, the Amazons, the Googles of the world that have been driving a disproportionate amount of the gains, and active managers have been penalized in those cases where they either don't own those stocks in their portfolios or they're underweight. So, it's been tough to keep up, and that's not something that has been a challenge for their peers that invest in overseas markets. What we saw was relatively a higher success rates among foreign stock-pickers. 

Now, if you look at active bond-fund managers, what you see is effectively, they got caught offside coming into this year. Many of them were structurally longer on credit risk. They were investing in more credit-risky securities, and they were worried about rising rates. So they were taking less interest-rate risk as they headed into the year. Now, obviously credit spreads widened out as the markets got very rocky, especially in the February, March time frame. They've since come back in, and rates have come down. So, what we saw is that success rates among active bond-fund managers were actually lower relative to stock-pickers. In total, they were about 40% across the categories that we examine in our study.

Benz: In the report, you do urge investors to look a little further out to examine the long-term performance trends rather than making too much of the six-month period. Let's talk about that. When you look at, say, time periods of 10 years or longer, one group that looks particularly undistinguished in terms of active management outperformance and survival is U.S. large caps. That appears to be fairly decisive from this report.

Johnson: Absolutely. I think, if anything, what we're trying to help investors with in this report is to focus on the signal. There's a lot of noise, as I've mentioned in the short term. Over the long term, there's some signals that ring through loud and clear in the results. And the first among those is really to focus on fees. What we see is that, almost uniformly, funds in the lowest-cost fifth of their category, those that charge the lowest expense ratios tend to have better than average odds of succeeding over the long term, while the most costly funds in any given category have below-average odds of succeeding. So focus on fees. This shouldn't be new news to most of the people who are tuning in for this conversation today.

The other, I think, important signal is to pick your spots. There are certain areas of the market where long-term success rates have tended to be higher. And where I think importantly, the payout profile--so the excess returns generated by those managers, the degree to which they outperform the average index fund in their categories--tends to skew positively. So what you see in the example of the U.S. large-blend category is that both the probability of picking a winning fund, as well as the payout profile as measured by that spread of returns relative to the passive funds, they don't look favorable from an investor's point of view. The odds are very low. Success rates are very low, over a 10-, 15-, and 20-year horizon, and the payout tends to skew negative.

So even if you find a manager that somehow manages to stay alive from beginning of period to end, most of them fall short of actually beating a randomly selected index fund within that category. Now, if you look at a category like foreign large blend, for instance, and select from the lowest-cost funds within that category, your success rates go up. You're nearly at a coin flip in terms of your odds: 48% succeeded from that lowest-cost quintile over the past 10 years, and the payout profile looks a lot better. If you look at the distribution of those returns, they skew more positively. So focus on fees, I think, and choose your spots are the two signals that we want to send loud and clear with the results of this research that we do.

Benz: Ben, really interesting research. Thank you so much for being here to share it with us.

Johnson: Thanks again for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.