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Active Equity Management Fails Again to Make Its Case

The latest fund-company missive fares no better than than its predecessors'.

Starting Well A couple of months back, Neuberger Berman issued a white paper, "The Overlooked Persistence of Active Outperformance" (Joseph Amato, Peter D'Onofrio, Alessandra Rago), that advocated active equity management. I was surprised and impressed. Surprised that a mutual fund company would hazard such a feat, in this day and age, but also impressed by its bravery.

However, I cannot score the effort a success.

The study begins promisingly. The authors evaluate multiple rolling time horizons rather than a single period; consider dead funds as well as those that continue to breathe; and use 20 years’ worth of data, which is long enough to be meaningful but not so lengthy that the early evidence might be misleading (because the times have changed). Those are sound decisions.

(As is common with performance studies, the authors judge funds by their total returns, rather than the academically sanctioned measure of risk-adjusted figures. That works for me. Risk-adjusted totals can be difficult to explain, and, for the most part, the risk differences among funds come out in the wash with such giant studies. As groups, the winners and losers tend to have similar risks.)

Massaging the Data However, things go downhill from there. The paper's major feature is to discard all funds that placed in the bottom quartile for the evaluation period. Unsurprisingly, this has the effect of improving active management's results. Whereas the pool of all actively run U.S. large-company blend funds beat the S&P 500 on only 33% of rolling 10-year measurements from 1999-2018, that amount doubles when the bottom-quartile funds are dropped. The revised figure is 66%.

(How eliminating 25% of funds could boost the study’s success rate by 33 percentage points has thus far baffled me. For purposes of this column, I will assume that my intuition is to blame, not Neuberger Berman’s math.)

Less clear--in fact, entirely unclear--is how somebody can spot those laggards ahead of the fact. To be sure, investors can screen on factors such as cost, stewardship, and Morningstar’s Analyst Ratings, but such items merely improve the odds, not eliminate them. In advance, one cannot identify anything close to the full component of bottom-dwellers, and without that information, Neuberger Berman’s conclusions disappear.

Only the Survivors Next, the paper switches from measuring rolling periods to single periods. The good news is that the outcomes improve dramatically. Again, Neuberger Berman jettisons the bottom-quartile funds, but in this case its findings don't need juicing. Over the trailing 20 years, for six of the nine surveyed fund categories--three large-company U.S. stock, three small-company U.S. stock, foreign large blend, diversified emerging markets, and world large stock--the average actively managed fund outgained the relevant index. Eureka!

Except, sadly, this test also required foreknowledge. The trouble with single-period calculations is that they may only be generated on surviving funds. Try as one might--and, rest assured, I have tried--there’s no useful way to incorporate funds that existed partially during a study. And there are a great many such funds. For example, Morningstar’s database contains 1,002 large-blend funds (oldest share class only). Only 137 possessed track records from January 1999 through December 2018, thereby qualifying for Neuberger’s white paper.

(The true number of large-blend funds that operated at some point during those 20 years is lower than 1,002, since my search was for all large-blend funds that ever operated. However, the point remains: By definition, research that accesses lengthy mutual fund histories leaves out more than it contains.)

Once more, investors entering the time period can narrow the field--indeed, more effectively than when trying to eliminate future underperformers. Funds that have low asset bases, mediocre track records, and relatively high costs are unlikely to persist. Even so, the task is too difficult. Nobody can recognize, in advance, substantially which funds will survive, and which will not. Those gaudy success rates could not have been achieved.

For the Hard Times? The authors then advance the bear-market argument. This likely will be familiar. Index funds, which are fully invested and possess no discretion, are fine for bull markets. However, they struggle with downturns. Active managers earn their pay for how they navigate the rapids. Today's investors don't pay much attention to risk reduction because more than a decade has passed since stocks last crashed, but they will appreciate active management's benefits when the next decline arrives.

That occurred with the New Era’s meltdown, when, by a modest margin, most funds across the nine categories held up better than their benchmarks. (Note: Neuberger’s test is appropriately stern, as it evaluates not whether the funds beat the S&P 500--a relatively easy hurdle for value and smaller-company strategies during the New Era sell-off--but instead whether the funds outdid their style indexes.) It did not hold during the 2008 financial crisis, though, as by an equally modest margin, most funds lagged their indexes.

The bear-market defense is therefore uninspiring. It sounds logical, and on occasion is valid. For example, hedge funds did largely avoid the New Era decline, and most international stock funds dodged the brunt of Japan's previous collapse. Generally, though, actively run stock funds don't meaningfully outperform the indexes during downturns. Perhaps the next bear market will be the exception. Perhaps. However, that would not be the odds-on wager.

Easy Money The paper concludes with another familiar common lament, that major central banks have damaged active management's results through their "highly stimulative" monetary policies, which have lifted all boats, regardless of their seaworthiness. Professional managers thrive when the times are difficult--when some companies will boom, and others will bust. When all firms benefit from easy money, those insights are squandered, because everything rises.

This carries the same credibility as the bear-market claim. The thesis seems reasonable enough. But it is untested. It also possesses the disadvantage of being created after the fact. (In 2009, no active stock managers advocated that prospective shareholders buy index funds instead, because lax monetary policies had eliminated active management’s advantages.) Could it prove correct? Sure. Once again, though, that would not be the way to bet.

This discussion, it should be emphasized, is purely theoretical. Nobody buys an entire equity-fund category. In practice, investors typically buy a single fund, or at most several. It may well be that their best choice, for reasons that lie outside of both Neuberger’s paper and this column, is actively managed. That certainly could be. My point is merely that while Neuberger’s paper implies selecting active management puts the wind at an equity investor’s back, the wind in fact blows from the opposite direction.

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.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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