How to Find Actively Managed Funds That Outperform
All is not lost.
Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Morningstar recently updated its semiannual look at how active funds are performing versus their passive counterparts. Joining me today to share some key findings from the report is Ben Johnson. Ben is Morningstar's global director of ETF research.
Nice to see you, Ben.
Ben Johnson: Thanks for having me, Susan.
Dziubinski: The latest report shows that only 47% of actively managed funds outperformed their passive counterparts during the 12-month period ending in June, and the success rate for actively managed growth funds was particularly bad. So, first, tell us a little bit about how bad is bad, and why was it so bad?
Johnson: Well, how bad is bad? So, just over a quarter of all active growth stock-pickers were able to outperform their average passive peer over the one-year period through June of this year. And why is it bad? Well, it's bad frankly because it's been bad for discretionary U.S. stock-pickers for a long period of time, the vast majority of which, irrespective of whether they lean toward growth or value or somewhere in between, have failed both to survive and to outperform their average passive peer over one-year, three-year, five-year, 10-year horizon, and beyond. Part of that is, frankly, it's just difficult for them to survive. Most funds over a long enough horizon fail. They're either liquidated or they're merged away. That explains a big increment of what we see in terms of their lack of success. The other challenge that we've seen more recently is--for growth funds in particular--growth has been leading value. Growth has been not just the style du jour but the style du the past 10 years or so, frankly. And when we see one particular style lead, what happens is that the purest expression of that style--so, a growth-focused index, be it large, mid, small, or all cap, becomes especially difficult for discretionary managers to beat because they tend to be stylistically messy. They color outside the lines and move over into blend and value names. They might move from large- to mid- to small-cap names.
So, in the past year, the year ending June 2021, what we saw is that growth again was surging and many managers, especially in the large-cap growth Morningstar Category, were underweight some of the names that were doing most of the heavy lifting in that category, most notably names like Apple (AAPL) and names like Google (GOOG), which they were, on average, very much underweight relative to the benchmark.
Dziubinski: On the flip side, we saw during this 12-month period that actively managed intermediate core bond funds actually did quite well. Unpack that performance for us.
Johnson: Yeah. So, what we see, much as is the case with discretionary growth stock-pickers, is that there's a lot of short-term noise in success rates across really all categories, and these short-term fluctuations, sometimes dramatic, as has been the case recently with the intermediate core bond category, are often explained by dramatic movements in the market. And in the case of this category, what we've seen is dramatic moves in credit markets. Specifically, we saw a very sharp drawdown into the teeth of the COVID crisis early last year and subsequently a very dramatic rebound off the bottom. So, what we've seen as a result over the 12 months through the end of June of this year is that as credit markets have snapped back, discretionary intermediate core bond managers were rewarded for taking on more credit risk. So, managers in general within this category take an added increment of credit risk relative to those funds that we're comparing them against--the passive peers in that category, most of which tend to track the Bloomberg Barclays Aggregate Index, which by definition leaves a lot of credit risk off the table, just given the makeup of the benchmark itself. So, that sharp uptick we saw in success rates within this category among active funds is largely explained by what we saw more generally in credit markets and the fact that credit risk was being rewarded.
Dziubinski: Ben, let's pan out now. As you alluded to earlier, the numbers over--there can be a lot of noise in a short-term, 12-month number, but realistically--over the past decade, active managers haven't in general had a ton of success against their passive counterparts. Have there been particular fund categories where active managers have done reasonably well?
Johnson: Absolutely. So, all is not lost, which is important to note. Part of the value of this exercise in setting base rates in terms of success or odds of success across different Morningstar Categories and across, importantly, fee sorts is designed to help investors to understand what attributes they should look for in funds that might help them to improve their odds of picking winners and what corners of the market are the odds stacked in their favor. So, if you look across the 20 categories that we examine in the U.S. funds market, certainly we see higher long-term chances of success, higher long-term success rates, when we move outside of the Morningstar Style Box and U.S. stock-pickers and into foreign categories, so foreign large-blend, foreign small- and mid-blend categories, as well as the emerging markets. So, diversified emerging-markets strategies have incrementally higher long-term success rates. Similarly, we see higher long-term success rates within fixed-income categories, be it intermediate core bond or, notably, in the high-yield bond space where, by virtue of being able to color outside the lines, active managers on average have, in many cases, been able to actually, somewhat reliably, add value.
The other all-important sort, too, that is important to understand is the fee sort. What we see is that almost uniformly less costly funds have higher chances of surviving and outperforming their indexed peers. The arithmetic of active management, as Bill Sharpe has described it, is absolutely ruthless, and it shines through in this data. So, if investors want to improve their odds of partnering with winning active managers, it's important that they pick their spots and keep a close eye on their costs.
Dziubinski: Well, Ben, thank you so much for your time today, both on updating us on the latest research and giving us some tips on how we can suss out those active managers who might be able to outperform. We appreciate your time.
Johnson: I appreciate you having me, Susan. Thank you.
Dziubinski: I'm Susan Dziubinski. Thanks for tuning in.
Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.