Active Management's Dilemma

The Math Problem The first thing most novice investors learn is that they are best off buying index funds. That's a fair starting point. Morningstar tracks the performance of actively managed funds against relevant indexes for 20 of the largest fund categories. In 17 of those 20 categories, the average actively run fund failed for the decade 2010-19 to keep pace with its benchmark. Of course, there were many exceptions, but the generalization is broadly correct.

The explicit problem for active management is that when it charges for its services, those costs harm its product. Paying more for an automobile, vacation, or tuition doesn’t change the nature of that car, trip, or education. In contrast, higher expense ratios directly and irreversibly reduce the performance of investments. If funds were sports cars, the steeper their price tags, the slower would be their acceleration. A Lamborghini would struggle to outpace a golf cart.

This logic has become so familiar as to be considered trivial--which, strictly speaking, it is. However, it’s worth noting that most investors believed otherwise for several decades. In 2001, a financial-planning magazine asked its subscribers to rank the importance of sundry fund attributes. Expense ratios placed seventh.

Forced to Explore Less appreciated is active management's implicit problem. If investors reject the higher costs of active management when cheaper index funds are available, then active managers must go where indexers are not. Their strategies become limited. Indexers may create any variety of fund, but active managers are constrained by the marketplace. They are forced away from plain vanilla, and into the exotic.

This situation existed long before index funds were a threat. In the 1980s, the key battle was not between active and passive funds, as the latter barely existed, but instead between load and no-load funds--that is, funds sold by financial advisors and funds that investors would buy directly. The former typically carried higher expense ratios, due to embedded sales and/or marketing fees. This placed them at a cost disadvantage to no-load funds.

The expense handicap did not bother those who marketed load equity funds, because the effect that costs have on total returns was not widely appreciated at the time. But it was a big concern for those who sold bond funds. Investors bought fixed-income funds mostly for yield, and the SEC requires that mutual funds pay their expenses from income (should they possess it), not from capital. Thus, load bond funds paid lower monthly dividends than did their no-load rivals. Investors noticed that, forcing load-fund sponsors to respond, or lose business.

Nonplussed Product management was up to the task. The major load-fund companies promptly launched "government-plus" funds, which sold call options on their long Treasuries, then distributed the options proceeds. Investors initially believed that government-plus funds provided a free lunch, but they eventually realized that their extra "yield" consisted not of actual income, but instead of short-term capital gains. They also began to understand that government-plus funds inevitably erode their net asset values, because such funds retain all their capital losses but not all their capital gains.

Shortly thereafter, government-plus funds went from being the industry’s top-selling category to being completely, utterly extinct. Every single government-plus fund changed its charter or was merged out of existence. The pluses, it turned out, were minuses. When portfolio managers did more, they delivered less.

This pattern was repeated, many times. “Enhanced-index funds” were created and then extinguished, while actual index funds remained. Tactical-allocation funds arrived after October 1987, disappeared, returned after the New Era’s collapse and the 2008 financial crash, then vanished once again. Do you wish to own an “American Government Bond” fund that supplements its Treasury positions with Mexican and Argentinian paper? Probably not. If so, though, you are out of luck. Such funds were decommissioned a few years after being created.

A Tale of Two Funds Another example: In the early 1990s, one investment manager sub-advised for two government-mortgage funds. One fund was Vanguard's and was cheap, while the other was for a load-fund company and was expensive. The two portfolios were radically different. The Vanguard fund's holdings were conventional. The other fund's investments were not, consisting almost exclusively of premium-coupon mortgages, which (you guessed it) pay higher current yields, but at the drawback of (you guessed it again) gradually depleting the fund's capital base.

The cost difference restricted the portfolio manager’s motion. Had the two funds been structured as clones, the load fund would have posted a subpar yield (as well as consistently and obviously posting lower total returns than Vanguard’s fund, because of the additional expense-ratio ballast). Marketing considerations prohibited that path. Therefore, the manager muddied the waters--and boosted yield--by adopting an idiosyncratic, and eventually unsuccessful, strategy.

A Fate to Be Avoided Although few today recall the details of these load-fund flubs, the events were powerfully important. They taught a generation's worth of financial advisors to distrust complex investment strategies, and to appreciate the merits of the simpler no-load funds that they had long marketed against. The industry's shift from selling commission-based investments to a charging an advice fee wasn't primarily driven by product features, but it was assisted by them.

The challenge for today’s active managers is how to avoid becoming the next version of load funds. They face a similar difficulty, in that their extra costs prevent them from confronting index funds directly. Instead, they must define new investment spaces; convince the marketplace that these new spaces are somehow superior to the established paths; and (critically) prove their theses with their performances. All without damaging their collective reputations by inventing fund categories that are not worse than the ones they intend to replace.

That’s a tall order. Although it may be achievable, history suggests that would not be the way to bet.

John Rekenthaler (john.rekenthaler@morningstar.com) 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.