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Rekenthaler Report

Examining the Results: Lower-Cost Active Management

Closing the gap with passive management.

Domestic Equity Funds
You know that passively managed funds tend to outperform actively run funds. That long ago ceased to be news. Nor is it novel to suggest that as actively managed funds go, lower-cost versions are preferable. What has been less discussed, however, is how passive funds stack up against lower-cost active funds. I’ve addressed the subject a few times, once when comparing the results for Vanguard’s active funds against its passive funds and then when reviewing an American Funds study. Today’s article expands upon those efforts by looking across the industry at several asset classes.

The numbers come from Morningstar’s Active/Passive Barometer, published in June 2015. That paper examined the performance of nine style-box categories of U.S. stock funds, foreign large-blend funds, emerging-markets stock funds, and intermediate-bond funds over various periods, sorted in various ways. This column is the Reader’s Digest version (I just dated myself there). It looks only at the longest of the time periods; restricts itself to two key calculations; and shrinks the U.S. stock funds down to the three groups of large, mid-size, and small.

Results for the U.S. stock funds, over the trailing 10 years ended in December 2014:

Let’s begin with the green numbers. For the columns of Survivorship and Annual Returns, green means “higher.” The picture tells the tale. Across the size spectrum, whether measured by the percentage of funds that survived the 10-year period, or by the gains of those funds that did finish the decade, passive funds triumphed. Impressively, they did so just as convincingly among mid- and small-cap funds as with large-company funds, although it is often believed that indexing is not as well suited for the “less efficient” small-company market.

Each of the three size groupings is further sifted into a “cheap” segment--those funds that have expense ratios that are among the lowest 25% in their categories. This exercise is conducted separately for active and passive funds, meaning that the active funds are those in the cheapest quartile of active funds, while the passive funds are the thriftiest of the passive funds. In all cases, for both active and passive funds, for both the survivorship and annual returns measurements, the numbers improved for the lowest-cost funds.

The competition tightens when comparing cheap actively managed funds to the average passive fund. The total returns become similar (for example, 7.15% for Large Cap All Passive, 7.27% for Large Cap Cheap Active) across the three sizes. For large-company funds, survivorship also becomes a dead heat, as the percentage of surviving funds jumps from a mere 54% overall to 67% for those active funds in the cheapest quartile. However, mid- and small-cap passive funds retain their survivorship advantage, even against the cheap active funds.

Unfortunately for active management, the story does not end there. Budget-priced passive funds must be considered, too, and that turns out to be a major factor. Surprisingly, the performance gap between the cheapest and average-priced funds is just as wide with passive funds as it is with active funds. The lowest-cost passive funds bolt back into the lead. As those tend to be the largest and most popular of passive funds, that is a significant victory for passive funds--even against the attractively priced active funds.

Three More Comparisons
Now for the other asset classes of foreign large-cap blend, emerging-markets stock, and intermediate-term bond:

Well, that looks different.

The survivorship lesson is the same as before. Passive funds were far likelier to last than were their actively run rivals. However, the return picture changed dramatically, as four of the six active rows turned to green numbers. Foreign Large Blend funds prevailed across both the All and Cheap segments, while the Emerging Markets Stock and International Bond categories lost the All battle but won with Cheap. (Once again, it’s ironic that active management lagged most sharply with emerging-markets stocks, which traditionally have been hailed as one place where active management is necessary. For one possible answer to the mystery, see last week’s column on Dunn’s Law.)

Another way of determining accomplishment is via a measure created by Morningstar’s Russ Kinnel, the Success Ratio, which neatly combines the two issues of survivorship and performance. A fund is considered to be successful over a period if it clears two hurdles. First, it must survive the period; funds that merge or liquidate are automatic failures. Second, if it does survive, it must post higher returns than does its category benchmark. (Strictly speaking, the fund should be asked to post higher risk-adjusted returns; but those numbers can be difficult to interpret, and as passive and active funds tend to have fairly similar volatilities, total return suffices.)

The Success Ratio supports the table’s initial impression: Moving from U.S. stocks to overseas stocks and to U.S. bonds improves active management’s outcome. The Success Ratios for the Cheap versions of the actively run Foreign Large Blend and Intermediate Bond categories are 59% and 55%, respectively, meaning that investors who picked an active low-cost fund at random a decade ago had a better than even chance of being able to hold that fund for the entire decade and to beat the index. In contrast, Success Ratios for the cheapest U.S. stock groups ranged from 38% to 46%.

These figures, too, form a familiar pattern. For much of the past quarter century, actively managed overseas stock funds and intermediate-term bond funds have competed well against their passive rivals. However, a note of caution is needed. Unlike with U.S. stock funds, where the active funds in aggregate look much like the market benchmarks, these three categories can diverge significantly. For example, few intermediate-bond managers invest as heavily in Treasuries as does the Barclays Aggregate. Thus, it’s difficult to tease out how much of active management’s better results are because of ongoing factors, as opposed to the temporary assistance of a benchmark mismatch.

For me, the conclusions are pretty straightforward. Contrary to occasional suggestions that active management is bad for an investor's financial health, lower-cost actively managed funds are about as good as the typical passive fund. Yes, there will be the occasional blowup with an active fund, but those occasions are becoming increasingly rare as the fund industry grows ever more risk-conscious. So there is not much reason to fear an appropriately priced active fund. However, while there are some positive signs with asset classes outside of U.S. stocks, it remains pretty hard to argue with a strategy of owning the lowest-cost passive funds.*

*As always, I make this argument in talking about pools of funds. Many will respond that they don't buy pools of funds, they buy one fund at a time, and that the funds that they own are good bets to be the exceptions. That is fine. I can't speak to anybody's ability to beat the odds. What this column can do, I hope, is to lay out the odds clearly, so that those decisions are made with full foreknowledge.

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.