The Empire Strikes Back

The View From 30,000 Data Points
Capital Group is on a PR tour. Making the media rounds does not come naturally to the company, any more than winning the Rose Bowl does to Cal Tech, but something had to be done. For the past half decade, at the very least, index-fund proponents and ETF marketers have owned the public discussion. As a result, active stock-fund managers are typically portrayed in the general media as useless at best, and harmful at worst. 

As the largest such manager, via its American Funds, Capital Group has had the most to lose. And lost, it has. Over the past few years, it has shed more than $200 billion of assets in net redemptions, most from its equity funds. Meanwhile, index funds and ETFs have gained more than $1 trillion of new monies. The Empire has received a thrashing.

Now it's telling its side of the story, via a study entitled "The active advantage: A history of delivering persistent above-benchmark returns." (Perhaps not the most engaging of titles.) Ostensibly, the study showcases the strengths of active management in general, as opposed to just those managers working at American Funds. However, that's not how the numbers play out. They show American Funds to be good. The rest of the industry, not so much.

The most notable aspect of the study is its long time horizon. Capital Group begins the analysis in 1934. From that point forward, it looks at all rolling one-, three-, five-, 10-, and 30-year (!) time periods, comparing the total returns of a) active stock funds overall and b) Only those from American Funds, against the returns of a relevant index. It's not the perfect study, but it's a good starting point, because it has a whole lot of data points and the results are easy to interpret.

Capital Group also looked at something it calls persistency, which measures the percentage of times that a winning fund (that is, a fund that beat an index) also won over the very next time period of equal length:

As is customary for performance studies, whether generated by American Funds, Morningstar, or academic researchers, fund returns are calculated net of all ongoing fees (that is, annual expenses) but do not include the effects of load charges.

Five Initial Thoughts
1) The success percentage for all active funds is much higher than generally believed. 
For the longer time periods, this is due largely to survivorship issues, as the most successful actively managed stock funds tend to stay in existence, and the less successful are merged away. (The same holds true for index stock funds.) Realistically, somebody purchasing a random stock fund at any point in the past 78 years and then holding it for the next 30 years would not have had a 38% chance of outgaining the relevant index. There's a very good chance that our investor would have been dumped into another fund at some point during those three decades.

For the shortest periods, say three years and less, survivorship is much less of an issue, so that the true results are close to the indicated percentages. Thus, when looking out for a year or two, choosing between an active fund or a no-cost index fund (if such a thing existed) is not a big deal. It's a roughly 50/50 proposition.

Overall, the figures cast doubt on the popular notion that actively managed stock funds are dangerous to one's financial health. They might not be particularly helpful, as a general rule, but not being particularly helpful is different from causing financial cancer.

2) The persistency of all active funds is disappointing.
The percentage of winning actively managed stock funds that were able to beat the index a second time was similar to the overall success rate for actively run funds for periods of five years and less but fell off the cliff for the 10- and 20-year horizons. (The big improvement for 30 years is surely a fluke caused by a very small sample size.)  Sequoia (SEQUX), famously, has been strong decade after decade. But the industry can boast few such funds. Most funds shine for a while, then fade into mediocrity. The lack of persistency is the biggest strike against active management.

3) The success percentage (and persistency) for American Funds is excellent.
No surprise there. As I've discussed in previous columns, American Funds has done well with its stock funds, over all time periods. Unlike with the all active list, these results are not aided by survivorship effects, as the organization has only killed off one stock fund during its history--50 years ago. For the long-term owner, holding an American Funds stock fund has consistently been a sound decision.

4) What about risk?
The study only lightly touches the subject. There's a brief look at the U.S. equity subset, showing that the American Funds are about as volatile as the S&P 500 index and that "like funds of other active managers" (I'm not quite sure what that means) are substantially riskier. That suggests that if the study were done on a risk-adjusted basis, so that Sharpe ratios rather than total returns were the measure of success, that all active funds would have fared worse and American Funds would have looked better. 

5) Is American Funds' success old news?
In aggregate, hedge funds have great 30-year figures--but that disguises the fact that they were terrific for the first 20 years, then mediocre since. The same might be true of American Funds; indeed, it probably is true given that the company now faces significant redemptions for the first time in decades.

That stands to reason, but it doesn't seem to be so. While American Funds didn't withstand the 2008 market crash as well as most expected, which led to bad publicity and investor disappointment, the company's stock funds have nevertheless kept pace with the indexes for the past five years and beaten them over 10. In fact, in a hypothetical exercise comparing the growth of $100,000 placed in a basket of American Funds and $100,000 placed in an index basket, American Funds fares best in recent years. It hangs around with the indexes through the 1980s and 1990s, then vaults past them beginning in 2000.

I suspect American Funds will recover its sales mojo. Fund performance has been good, and memories of 2008 will fade. Other active stock-fund managers will continue to struggle, even if Capital Group successfully spreads the word that active managers as a whole are reasonably safe and acceptable alternatives to indexes. Safe and acceptable beats being financial poison, to be sure, but it's not enough incentive to get investors to change their current habits.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.