Friendly Fees Spell Success for Passive Foreign-Stock Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Are you better off buying an actively managed foreign-stock fund or sticking with an index product? Joining me to share some research on that topic is Dan Sotiroff. He is an analyst in Morningstar's passive strategies research group.

Dan, thank you so much for being here.

Dan Sotiroff: Glad to be here.

Benz: Dan, you and the team work on something called the Active/Passive Barometer. I think it's such interesting research where you go category by category and look at the performance of actively managed funds relative to their index fund counterparts. And I want to focus specifically on the foreign-stock piece of this because we've seen investors actually seeming to prefer passively managed products here quite recently. So, let's start with the foreign large-cap funds, where most of the foreign-stock dollars are. When you look at actively managed funds versus index funds, which have looked better?

Sotiroff: Well, it's interesting because it's kind of evolved over time. So, I think if you go back maybe 15-20 years, U.S. large-blend category active success rates are probably around 15% to 20%. If you went into the foreign large-blend category, which as you said that's where a lot of people have most of their money parked, the success rate has been notably higher, more like in the 30%-40% range. What you've seen over time is that has come down, and I think that's really just a byproduct of fees really coming into play. You have a lot more passively managed dollars out there. People are more aware than ever that fees are a big part of this. So, I think fees are probably the overriding thing. I think the other thing was, historically, active managers had some things they could do because you have so many more options in the foreign market space.

Benz: So, in terms of country weightings, downplay this country.

Sotiroff: Bingo. Exactly. So, you look 20-25 years ago, just underweighting Japan was a great move.

Benz: That was slam dunk, right?

Sotiroff: Yeah exactly, an easy one. And then even over the past 10 years as we've come out of the Great Recession, foreign stocks just haven't performed very well. So, when a market doesn't perform well, index funds tend to not look as good in the category against their actively managed peers, and really that's because active managers can do things like hold cash, maybe hold some more-defensive names, or even just hedge currency or hold U.S. stocks, they don't have that currency exposure. So, there are things that active managers can do to play around the edges that benefit them a little bit. But when foreign markets come back, it's probably going to hurt them in the long run.

Benz: How about a year like 2018 where foreign stocks performed pretty poorly? How did active funds do relative to index funds?

Sotiroff: They did come back a little bit, but I think what you're seeing, though, is those fees are starting to eat more into their returns. So, what you see in the foreign large-blend category, again, is they got knocked--the success rates got knocked, so they are coming down over time. And I think, again, as you see more and more of these foreign index-tracking funds and strategic-beta funds come into the play that are charging very low fees for similar style exposures, it's only going to erode active success rates in those categories.

Benz: Let's talk about some of the more specialized fund types. Starting with foreign small caps. These funds are less widely owned but nonetheless pop up in some investors' portfolios. When you look at the data, the long-term data, what do you see?

Sotiroff: So, the success rate again is much higher in that area because really what I see there is you didn't have as many options 10-20 years ago. So, you maybe had one or two passive funds in the category, and since there wasn't a lot of competition, you probably didn't have to cut your fees a whole lot. But what you are seeing now as time has moved on as more and more competition has moved into that space, you are seeing much lower fees. Again sort of the strategic-beta, simple market-cap index funds are moving into that space, much lower fees, similar style exposure, and they are really taking it to the active funds. And the success rate hasn't come down as much as the U.S. and the foreign large-blend categories, but I expect that it's going to in the years ahead. It's been pretty interesting to see how that space has evolved over time.

Benz: Emerging markets would appear to be an area where maybe if I am trying to decide between some sort of passively managed product or an active fund, it might actually give the edge to the active fund based on the data, what do you see when you look at long-term success rates?

Sotiroff: That's a good point. This is really more of a category-relative ranking. If you look at emerging-markets indexes, they are pretty heavily weighted in China right now. Most indexes are somewhere between 30% and 35%, depending on the actual composition of the index. So, that's a pretty heavy country weighting. It's going to be highly susceptible to the Chinese market, whatever it does. I think you actually saw that play out last year. China didn't do as well as the broader MSCI Emerging Market Index. So, that kind of hurt some of these index trackers. Active managers that underweighted China actually did a little bit better. Again, though, I think in the long run, fees are really going to count more than any of these country weightings. So, it's interesting to see what has happened over the past year in that category. It's indicative of what we would expect, but going forward, low fees, I think, are ultimately going to rule the day.

Benz: A related question: One comment I have heard is that in some of these very volatile categories, whether foreign small caps or emerging markets, that expenses are a less important differentiator than is the case in a category like foreign large blend, where the range of returns might be pretty tight. What do you think of that comment?

Sotiroff: It has been historically, but again, you see the low-cost competitors coming into the space--and it's just the fee differential. If we go back to the foreign small-blend category, the fee differential between a Vanguard fund that's charging 12 or 14 basis points and the average active fund that's over 1%, that's just a huge hurdle they are going to have to overcome, and I just see that as a really, really difficult task ahead for any active manager. I think, in general, if you're going to be in an active fund, you need to be cheap, let's say bottom-quintile at least in order to be competitive in those spaces and really in any of these categories broadly, because low fees are coming in, and it's going to be really, really competitive in the future.

Benz: Okay, Dan, interesting research. Thank you so much for being here to share it with us.

Sotiroff: You're very welcome. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.