Actively Managed Funds Continue to Underperform

The most recent bout of market stress brought back familiar headlines from past drawdowns: "It Is Active Managers' Time to Shine" and "Stock-Picking Is Back." Active managers who are afforded flexibility in their mandates are more capable of navigating market volatility than their rigid passive peers—or so the thinking goes. However, of the nearly 3,000 active funds included in our analysis, only 40% survived and outperformed their average passive peer in the 12 months through June 2022, casting doubt on active managers' reputation for deftly navigating troubled markets.

We further analyze these findings in the midyear 2022 installment of the Morningstar Active/Passive Barometer, a semiannual report that measures the performance of U.S. active funds against passive peers in their respective Morningstar Categories. The Active/Passive Barometer spans more than 8,000 unique funds that accounted for approximately $15.6 trillion in assets, or about 69% of the U.S. fund market, at 2022's midpoint. The full report can be found here.

You can learn more about the background on our approach to the report in this article.

Most Active Managers Have Failed to Capitalize on Volatility

When viewed as a whole, an active fund had below a coin flip's chance of surviving and outperforming its average passive peer over the 12 months through June 2022, although results varied widely across asset classes and categories. For example, U.S stock-pickers handled volatility much better than foreign-stock funds. Forty-five percent of the former cohort outgained their average passive peer in the 12 months through June 2022, while only 23% of the latter group did.

Overall, active bond funds have had a rough year, with just 29% besting their average index peer over the past year. Active managers had a tougher time in corporate bonds (22% success rate) than high-yield bonds (32%). The one-year success rate for active managers across the three fixed-income categories dropped 44 percentage points from their mark in 2021. Exhibit 1 details the year-over-year change in success rate by category from the trailing 12 months in June 2021 and June 2022.

But one year isn't a sufficient time horizon from which to draw conclusions. Success rates can fluctuate wildly from year to year, depending on what's going on in the markets and how that reflects in the biases in active funds' portfolios as well as in the passive funds we measure them against. For example, many active bond funds tend to take more credit risk than their index peers. Their success rates tend to rise when this risk is rewarded and fall when credit spreads widen, as they did this year.

Longer horizons provide stronger signals that investors can incorporate in their selection process. In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons. Only one out of every four active funds topped the average of their passive rivals over the 10-year period ended June 2022.

But success rates vary across categories. Long-term success rates were generally higher among bond, real estate, and foreign-stock funds. Investors can use this data to identify areas of the market where they have better odds of picking winning active funds.

Sizing Relative Performance of Passive and Active Investing

Success rates alone only tell half the story. The other half is the prospective payoff for choosing a winning fund and the penalty for picking a loser. The Active/Passive Barometer contains this information in the form of plots of the distribution of 10-year excess returns for surviving active funds versus the average of their passive peers.

Much like success rates, these distributions vary widely across categories. In the case of U.S. large-cap funds, the distributions skew negative. This paints a bleak picture for active funds in these categories given the low long-term success rates and high penalties associated with picking a loser (per the negatively skewed distribution) relative to the potential rewards from picking a winner.

The opposite tends to be true for some of the fixed-income and foreign-stock categories that we examined, where long-term success rates have generally been higher and excess returns among surviving active managers skewed positive over the past decade. Exhibits 3 and 4 show the distributions of excess returns for surviving active funds from the large-blend and diversified emerging-markets categories.

Costs Matter for Both Passive and Active Strategies

The signal that rings loud and clear in this data set is that fees matter. The cheapest funds succeeded far more often than the priciest ones (32% success rate versus 19%) over the 10-year period through June 2022. This not only reflects cost advantages but also differences in survival, as 65% of the cheapest funds survived, whereas 57% of the most expensive did so.

If there's one near certainty for investors, it is "you get what you don't pay for," as Vanguard's late founder Jack Bogle said.

Correction: This article was originally published with incorrect data. The exhibits and some of the figures have been revised (Sept. 27, 2022).

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