Active Funds May Look Better, but Still Not Great
Christine Benz: Hi, I’m Christine Benz from Morningstar.com. Actively managed fund performance looked a little better in the first half of 2019 relative to passively managed funds, but the long-term story is still pretty dismal. Joining me to share some context around the latest data is Ben Johnson. He’s Morningstar’s director of global ETF research. Ben, thank you so much for being here.
Ben Johnson: Thanks for having me, Christine.
Benz: Ben, you and the team put out this Active/Passive barometer twice a year, and the most recent data-run came out not so long ago. So let's discuss the short-term results. When you went category by category, and you look at success rates of active funds relative to their passively managed counterparts, you found a little bit of improvement in the first half of 2019 right?
Johnson: A little bit. There were some categories where we saw pretty material improvement in that short-term look-back, so the one-year period that ended in June of this year, most notably among mid- and small-cap managers in U.S. stocks that occupy either the blend or the growth column of the Morningstar U.S. Style Box. What we saw there was actually a material year-on-year improvement in their success rates, which isn't uncommon to see in these shorter time horizons. What we tend to see is there's a lot of noise, and in this particular instance what we saw was actually reflective of the biases that are inherent in those manager's portfolios, and the makeup of the indexes that underpin the passive funds that we're comparing them to.
So, specifically in this case, it was a period of time during which large-cap stocks outperformed small-cap stocks by a very wide margin. Managers in those categories tend to tilt more towards larger-cap names. The indexes that we measure them against tend to tilt smaller, so effectively, the bar was lower for them during that one-year look-back. So, there's a lot of noisiness in these short-term look-backs, be it one, three, and even five years, that can give investors a head fake and kind of conjure the idea of this mythical concept of a stock-picker's market--that active management is making a comeback.
Benz: So, as you said, it's the long view that really matters, and so let's take a look at the 10-year period, for example. Overall, not a great picture for active management. Some categories, some even asset classes, look better than others. But let's just talk about domestic equity. Not a great story for active managers.
Johnson: Definitely not, and what we try to ground investors in in this report is a sense of probability, and now, in this latest report, sort of a concept, or an expectation, as to the payout. So, when I say "probability"--what are the odds in any given Morningstar Category of selecting a winning manager? In which categories are your odds better, in which categories are they worse, and what other variables can you look at that might help to boost your odds of picking a winner? So, category by category, if we go to the example of, say, U.S. large-cap blend, what we see is that the probability of finding a winner over the long term, as we look back in time, is very low.
Benz: The success rates are really low?
Johnson: Absolutely. So success is defined by, first and foremost, survival.
Benz: Not getting merged away or something like that?
Johnson: Shuttered, merged away, which tends to happen not because you're doing well.
Benz: And it happens more than investors might think, right?
Johnson: Far more than investors might think. So over a long look-back, roughly half of funds in any given category ...
Benz: It's incredible.
Johnson: ... might not make it. So, probabilities are one thing. Do I survive? Do I deliver a return that's better than the average of my passive peers? The payout is the other bit. So, what am I going to get if I do find a winner? If I'm making a bet, I don't want to know just the odds, but I want to know what's my payday going to look like? So, for the first time in this most recent report, what we included is a snapshot over the trailing decade of the excess return, so, either the out- or the underperformance relative to the average of the passives in the category of surviving active managers. And what we see--which is, in the case of U.S. large-blend funds, a double whammy of sorts--is not only is the probability of finding a winning manager low, the expected return is actually negative. So, the median excess performance of those active managers in that category versus their passive peers is below zero. So that's an area where investors should probably default to indexing.
Benz: Which they seem to be doing.
Johnson: Which the flows would corroborate exactly that. Now, there are other areas of the market where those variables look very different. So, if you go outside of the U.S. and into foreign stock markets, the Morningstar foreign large-blend category, what you see is probabilities are far greater, especially if you focus on fees, which applies across all categories. Lowest-cost funds tend to outperform the highest-cost ones, so probabilities are better in this category, and the payout, as measured by the median excess returns of surviving active managers, is positive. So this is an area that's more rich with opportunity for investors looking to find a partner for the long term amongst the lot of active managers that's out there today.
Benz: So not only is your chance of picking a winner within a foreign stock category better but also your chance of picking an active foreign stock fund that will beat its category, its index category peers, meaningfully?
Johnson: By an amount that warrants the risk of potentially partnering with a dud, with a loser.
Benz: OK, Ben, fascinating research. Thank you so much for being here to discuss it with us.
Johnson: Thanks for having me.
Benz: Thanks for watching. I’m Christine Benz for Morningstar.com.
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