Downturn Protection Not a Reason to Go Active

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Did actively managed equity funds earn their keep during the recent market downturn? Joining me to share some research on that topic is Jeff Ptak. He is head of global manager research for Morningstar.

Jeff, thank you so much for being here.

Jeff Ptak: Thank you, Christine.

Benz: You took a look at how actively managed U.S. equity funds did during the downturn that we had in early February. Let's talk about how they compared to their passively managed counterparts.

Ptak: This was actually, albeit a very short period of time, actually a pretty good period for actively managed U.S. equity funds. Not quite 60% of unique active U.S. equity funds beat their benchmarks during that late-January, early-February period where we saw volatility spike. This came amid what's been a pretty desultory period for actively managed U.S. equity funds. They have really struggled. In a sense, this provided a bit of relief to those funds and investors in them.

Benz: One thing that showed up in your data was that the value-oriented funds, the active funds, actually did a little bit better than their growth counterparts. Let's talk about that.

Ptak: They did, yes. I would say that one of the bugaboos for the indexes recently has been energy. Energy has been an area that's been under pressure for quite some time. Some of those energy names where the index went down quite a bit. In aggregate, I think that we would say of the value funds that had energy exposure, maybe they were a bit light in it or they owned some names that didn't go down quite as much as the constituents in the index. That was an area where value-oriented active funds were able to make a bit of hay versus their value indexes, and that explains why the success rates were higher for those types of funds in this recent period and over the year-to-date period for that matter.

Benz: The question is, whether this outperformance that we saw with active funds during this very short period, whether that's persistent, whether there is any reason to believe that actively managed funds will continuously be able to show their mettle during periods of market weakness? Do you think that assertion really stands?

Ptak: We do hear that talk quite a bit, especially from active managers, whose interest it serves. There is a kernel of truth to the notion that active funds perform a bit better during downturns. When we have done research over the past two decades, U.S. equity funds in particular, what we have found is over rolling three-year periods they do tend to succeed more often in three-year periods when the indexes are down. They do tend to do a bit better in down market periods.

There's a couple of problems though. One is that we have far more up periods that we do down periods. The second is that we see active funds, they don't persist in their outperformance. If you look at a subsequent three-year period after a fund outperforms, it doesn't maintain that outperformance. It basically decays over time. That's when we look at longer-term measures, five-year success rates, 10-year success rates, the numbers are well below 50%. In fact, in some of the reports that we run like the Active/Passive Barometer, we find that the success rates in many categories are well below 30%.

Benz: That brings me to my next question, which is, if I want a fund or a group of funds in my portfolio that will consistently perform during those periods of market weakness, that I'm kind of looking for that downside protection, are there any characteristics that I should be looking for when I am shopping for holdings?

Ptak: After you kind of go through your progressions and make sure that you've got the right asset allocation that meets your goals--which probably supersedes everything--and you turn your attention to your actively managed funds, I would say that some of the things that we would look at as analysts is how does the manager articulate his or her strategy; are they absolute return-oriented or are they more relative-minded where they are willing to own less overvalued stocks but stocks that are overvalued all the same. Are they sector-concentrated; do they have big positions in individual names; how often do they trade; what sort of forethought does it seem they put into the positions that they put on in the portfolio? Those are all sorts of considerations that our analyst would try to take into account in making an assessment of how robust the risk management process or a particular equity manager has. It probably well serves investors to go through those same sorts of progressions when they are doing their own sort of diagnostics on their actively managed holdings in their portfolios.

Benz: You kind of hinted at this in an answer to a previous question, but when you kind of dial it back, get away from the periods of market weakness and look at the whole mosaic of market performance, you said that actively managed funds as a group don't look particularly compelling. A lot of advisors, certainly, and individual investors are kind of using that as an impetus to say, forget it, I'm just going to own an all-passive portfolio and call it a day. Is that a legitimate way to approach things, do you think?

Ptak: It is, and it isn't, which is a bit of a dodge. It is in a sense that I think that many advisors and investors are maybe recognizing their limitations, or they are recognizing that there are other considerations that take precedence over finding the most skilled active manager out there. Perhaps it's minimizing costs, perhaps it's calibrating their exposures, maybe it's driving higher tax efficiency--all of which can be facilitated more easily through a passive vehicle.

It isn't in the sense that you don't want to throw out the baby with the bathwater. There are some active funds that are out there that are manned by legitimately skilled investors that maybe have some sort of competitive advantage that they can wield over time. Sometimes it's prosaic as a cost advantage; other times it's time arbitrage. They are more patient than other investors for whatever reason; maybe it's because they have a very deep and experienced analyst team. You have to sift through that and do you pick-and-shovel diligence work to identify those managers. With perseverance it can pay off.

As you rightly point out, when we run the numbers, they don't lie. There's relatively few active funds that succeed over longer periods of time. It ranges anywhere from about 10% to 35% over a 10-year period when you take fund deaths into account. The odds are not in an investor's favor. That's why I think that most are probably better off, if they can't put in the work that they don't have to resolve, sticking with passively managed products.

Benz: I want to just poke at this value idea a little bit, backing away from down market periods and looking at active value funds more broadly. When I look at that Active/Passive Barometer, some of the value funds do look a little bit more compelling on a long-term basis, the actively managed funds. What do you think is going on there?

Ptak: It's probably a couple of things. One is, when we back up and think about the discipline with which fund companies introduce funds, they have tended to be a bit more disciplined when it's come to value strategies. And why is that? I mean, value is just not as sexy a story. With growth there tends to be narrative with it. It's a little bit easier to sell. I think the corollary to that is that many fund companies have been a bit less disciplined in bringing products out, and what that's meant is that many of those products, because there wasn't the forethought put into them have failed over time. Whereas with value, you've kind of got to have it steely resolve, the determination, really be committed to the underlying investment discipline. It doesn't mean they all succeed, but I think it gives them a bit more of a fighting chance.

The other thing which is a bit more cyclical in nature, we have seen growth over an extended period of time outperform value. What that tends to mean, value managers tend to be a bit less style-pure than their indexes. They might tilt a bit more toward core and towards growth whereas their index is going really stay in that left-hand column in value. That maybe gives them a little bit of an extra kick, a little bit of an extra tailwind, because they haven't loaded as much to value as they typically would. I think that's a bit more unique to the last five or 10 years than if we are talking about decades of market experience. I think that's probably also a factor that explains why value funds have had a bit more success in the last five, 10 years than have active growth funds.

Benz: That could be fleeting though?

Ptak: It could be fleeting, absolutely.

Benz: Jeff, always great to hear your insights. Thank you so much for being here.

Ptak: My pleasure. Thank you.

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