A Bad Year for Active and Passive?

As you may have heard, last year was a tough year for actively managed funds. You may not have heard that it was an even tougher year for index funds. In 2012, the average index fund had a percentile ranking of 53--meaning it was slightly below peers and thus the average actively managed fund. 

How is that possible? Well, most active/passive reports you see in the news focus on comparing actively managed U.S. equity funds with the S&P 500's returns. If less than half beat the benchmark, the media says it was a bad year for active management. Some people then take that statement to mean that you shouldn't bother with actively run funds. But consider what they are assuming: First, that you can't do better than average with actively managed funds--essentially, we can only throw darts at the fund listings. Second, they are assuming that the alternative is a cost-free index. So, active investors are dolts while index-fund investors somehow can get an index without any cost.

That's why I like to look at index-fund performance. It shows what's wrong with that logic. Another flaw is the assumption that the S&P 500 is the right benchmark. More than 90% of actively managed U.S. funds have average market caps below the S&P 500's. Thus, you are not comparing active with passive. You are comparing mega-caps with the rest of the market. Sure enough, in all of the years when active strategies are said to be foolish, the big names at the top of the S&P 500 perform better than small- and mid-cap names.

A few years ago, I created custom benchmarks for the nine Morningstar Style Box categories that accurately reflected where actively managed funds invest, because these funds tend to spread out across the style box. When you make that adjustment, a remarkable thing happens: The good year/bad year notion goes away. Then you see that about one third of actively managed funds beat the custom indexes each year regardless of how mega-caps fared. If you go another step further and look at index-fund performance versus active, you see that active improves to better than that one-third figure, though it's still below 50%.

Of course, the pro-index crowd is not alone in this goofiness. Firms with only actively managed funds like to trot out the idea that the next year is going to be a "stock-picker's market," usually because the market will be flat. But as my above point shows, this never happens. Actively managed funds don't have a greater chance of beating an index in flat markets than in other markets. It is even less likely that someone can predict when those stock-picker's markets will come.

I'm agnostic about index and actively managed funds, as you might have inferred from the fact that we give Gold Analyst Ratings to the best of both groups, but most do not earn that rating. Either way, you need strong fundamentals such as low costs, good strategy, and sound management. Throwing a dart at active or passive funds will not likely get you where you need to be.

Build a plan for active and passive funds and stick to it. Tune out the reports of which camp did well and which did poorly or forecasts to that effect. Actively managed and index-fund companies are just promoting their products, and reporters are just filling space with fluff. Investing for the long term in good funds is what succeeds.

So, was it a bad year for index funds and active funds? I'd say it was really a good year for both. They earned double-digit returns for shareholders. I'll take that anytime.

This piece originally ran in the February issue of Morningstar FundInvestor. 

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