Did Active Funds Finally Outperform in Temperamental 2020?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Morningstar recently published its semiannual Active/Passive Barometer report. So, how did the performance of active funds stack up against their passive counterparts in the volatile year that was 2020? Joining me today to discuss key takeaways from the report is Ben Johnson. Ben is Morningstar's director of global ETF research. Hi, Ben. Thanks for being today.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Let's start out broadly. How, in general, did active funds' performance stack up relative to the performance of passive investments?

Johnson: Well, what we saw in 2020, Susan, was that at year's end, just shy of half, so 49%, of the 3,500 or so actively managed funds that we include in our analysis, managed to both survive and outperform the average of their passive peers during the 2020 calendar year. Now, that's what we would define as success in the context of this report, surviving over a given period and outperforming that average peer, which is our index, which is about a coin flip and is about what you would expect all else equal over a long period of time from actively managed funds--that half would probably outperform, half would underperform.

Why this is a bit eye-opening is that for a long period of time there has been this prevailing narrative that in conditions such as those that we experienced in the markets in 2020, active managers might actually do markedly better than their indexed peers, which are destined to just mirror the markets and have no real ability by definition to either out- or underperform the markets. So, what was notable about the fact that just 49% of them managed to outperform their average peer was that they were given the opportunity to do much better in what was an unprecedented market environment in many of our lifetimes.

Now, to be fair, it was also unprecedented because the violence, the speed, at which markets drew down and then subsequently recovered was also unprecedented. Even famous investors like Warren Buffett lamented the fact that they simply couldn't move quickly enough, that the opportunities weren't present for long enough for them to really be able to exploit them, which speaks to the fact that we saw another sort of intervention without precedent, which was the speed and magnitude with which the Federal Reserve intervened to backstop markets, to support them, to help right the ship when it was down and going down in a big way, in a fast way, in the first quarter of 2020.

Dziubinski: What is this performance saying in general about how actively managed funds really do handle market volatility relative to passive investments?

Johnson: Well, I think what it says is that there's really only so much that managers can do in how their portfolios respond, how they respond, to market volatility depends in large part upon their strategy. But what I would say, and what we've seen now for the years that we've been publishing this report, is that success rates among active funds over the very short term--and I include not just the one year look back in the short term, but even in some cases three and five years--are very noisy. I think they say more about the tendencies of active managers, about some of the biases in the indexes that underpin their passive peers, than they contain any like real useful signal, any real useful information for investors. Where the signal kicks in is over longer look-back periods, looking back 10 and 15 and 20 years, and that's where some of the more useful information that we've been able to divine, to suss out, from this analysis over the years starts to ring through all of that noise that we see over shorter time frames.

Dziubinski: In 2020, were there any particular parts of the equity market where actively managed funds were able to outperform?

Johnson: What was notable in 2020 was that despite the fact that value stocks had a terrible, horrible, no good, bad year, the Morningstar U.S. Value Index was down 2% in 2020, the Morningstar U.S. Growth Index was up over 44%. What we saw actually, which might be counterintuitive for some, was that success rates among actively managed value funds across the large-, mid-, and small-cap value Morningstar Categories actually spiked materially higher--14-percentage-point increase in success rates among those funds versus 2019. And what that speaks to first is some of the noise that I mentioned before and also speaks to the influence of something that's called Dunn's Law, which is a concept that argues that when a particular strategy either performs quite well or quite poorly, actively managed funds, active managers that adhere to that particular strategy, that fit in that particular style box, are either going to have a difficult time keeping up when that strategy performs well or going to do relatively well, as we saw with value last year, when it performs poorly. That's because the indexes that represent value stocks or growth stocks, or all stocks, they're the purest expression of that strategy. And what we see is that most managers aren't necessarily that style pure. They tend to color outside the lines. So, a large-cap value manager might own some mid-cap stocks, they might own some small stocks, they might own some blend stocks, and they might even own some growth stocks. So, when value does really badly, as it did last year, it actually lowers the bar for managers in that space. And we've seen actually the flip side has been true for managers in growth categories. Growth as a style obviously has been performing tremendously well over recent years, and that's really squeezed success rates across the board when you think about that right-hand column of the Morningstar Style Box, which is the neighborhood of large-, mid-, and small-growth managers.

Dziubinski: Let's pivot over to fixed income. Are there certain bond categories where perhaps active management was able to do a little bit better last year than passive?

Johnson: Yeah. So, I think, last year and even over the longer term, what we've seen is that across the fixed-income categories that we included in our analysis, which are three--they include the intermediate core bond category, the corporate bond category, and the high-yield bond category--success rates amongst active bond portfolio managers have actually been systematically higher than what we've seen among stock-pickers, and that speaks to a number of different factors.

I think one of the factors in play there is that the indexes are inherently encumbered in those cases, the indexes that underpin passive funds, mutual funds and ETFs, relative to their active peers. So, they have a very strict definition of what they can invest in, the bonds that they select for their indexed portfolios, and how they weight them. So, taking, for example, the Bloomberg Barclays Aggregate Bond Index, which underpins most of the largest bond index funds, that, by definition, is limited to investing in bonds that are of investment-grade credit ratings.

Now, what we've seen over the years is that many active bond managers are able to add value by either overweighting lower-rated investment-grade corporate bonds or other investment-grade-rated credits or crossing the line a bit in dabbling in some high-yield bonds, which over longer periods of time has helped them to generate excess returns relative to their more-limited, their more-constricted passive peers. So, especially if you're to focus in those fixed-income categories on the least costly funds, what we've seen is that success rates among those active managers have been materially higher than what we've tended to see in the U.S. stock space.

Dziubinski: Now, over the long term, across the categories that we've looked at and studied, we have found that in most categories, passive funds do have a pretty significant performance edge over actively managed counterparts. What should investors take away from that?

Johnson: I think going back to what I was alluding to earlier, Susan, some of the key signals that we see in that longer-term data is, first and foremost, one of the biggest factors that causes active funds to fail is that they fail to survive, and they fail to survive oftentimes because they fail to outperform either their indexes or a relevant benchmark. So, survivorship is a big factor in long-term success rates for active funds as well as many passive funds. There are certain categories where any number of index funds have come and gone over the years as well. Survivorship isn't a uniquely active fund story. It applies to index strategies as well.

The other signal that comes through loud and clear and should be no surprise to many investors is that costs matter. What we see is that long-term success rates among the least costly funds in any given Morningstar Category tend to be higher than the category at large and tend to be markedly higher than success rates among the most expensive funds in those same Morningstar categories. So, focusing on fees is critical.

The other signal that is really clear, as I mentioned before with fixed-income strategies, is that investors should pick their spots. There are certain areas of the market that are just inherently more difficult for active managers to add value in. And the U.S. stock market has been the most prominent among those. But if you move outside of U.S. stocks into either bonds or certainly into foreign stock markets, what we've seen is that stock-pickers in foreign stock markets in categories like the foreign large-blend category, diversified emerging markets, have had also systematically and materially higher success rates relative to their peers. And what we've also seen, because we include the measurements of equal- and asset-weighted returns in our analysis, is that in some cases, especially in foreign stock markets, investors have done better as measured by their asset-weighted returns in funds in those groups than they have with index funds. So, all is not lost for active managers. I think by focusing on fees and picking their spots, investors can be very well served by discretionary portfolio managers across any number of different categories.

Dziubinski: Ben, thank you so much for your time today and for the update, and we will check back in with you in six months after Morningstar updates this report for the second time this year. We appreciate your time.

Johnson: I'm looking forward to it, and thank you for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

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