One Very Big Strike Against Active Management

Contrary to the popular belief that active management makes more sense when buying small companies than when purchasing heavily researched blue chips, the SPIVA report found that active large-company stock funds fared best. Although best in this case meant “least awful,” with 92% of large-company funds falling short of their benchmark, as opposed to 93% for small-company funds and 95% for those funds investing in mid-caps. So much for the conventional wisdom.

The paper then examines other asset classes, and finds similar lack-of-success rates. Ninety percent of emerging-markets stock funds failed to match their benchmarks. For intermediate-government funds the figure was 82%, and for general international-stock funds 89%. Wherever one looks, the answer is pain.

Thus, while the common story is that active fund managers struggle to beat the S&P 500, or perhaps the U.S. stock market overall (the tale that the Journal told), the victory for indexing extends far more widely than that. Across the board, in every category that the SPIVA paper examined, the benchmark triumphed for the 15-year period. There were no exceptions. The first view of active management, it must be said, is very bad indeed.

Live and Let Die

This grim news does carry two positive caveats. The first is that those wretched actively managed success rates are heavily influenced by survivorship bias. In the SPIVA study, any actively managed fund that existed as of January 2002, and then merged or liquidated at some time during the next 15 years, is counted as a failure. The only winners, per its measurement, are those funds that accomplished two tasks: 1) operated for the entire 15 years, and 2) outgained the benchmark.

That is a valid approach; indeed, I have used the same logic when evaluating the performance of the Morningstar’s Rating for funds. It is not enough to look only at funds that currently exist when attempting to assess performance. One must also take into consideration those funds that have since departed. To ignore the dead is to bias the results upwards, because almost surely the funds that were terminated were, on the whole, less successful than those that their companies chose to keep alive.

Nonetheless, a failure caused by performance is not the same as one caused by liquidation. With the former, the investor absolutely, positively would have been better off holding the benchmark. With the latter, we do not know. We know that the original fund ceased to exist, thereby freeing up monies to be reinvested elsewhere. It is quite possible that those assets were put to good use. Our assumption is universally negative; however, the actual outcome is not.

And the survivorship hurdle has a huge effect. For example, only 34% of U.S. large-company funds finished the 15-year period. The numbers are higher for most other categories, particularly with municipal-bond funds, but overall, only about half of all funds lasted the full 15 years. Thus, the success rates among those funds that persisted are roughly double the rate that the study suggests.

Costs Matter

That silver lining for actively managed funds, of course, is more lining than silver. Having many funds expire along the way, with those that do survive still generally lagging the benchmark, does not a glorious achievement make. But there is a way to improve the odds considerably—by sorting on costs.

This finding comes not from the SPIVA paper, but from my own company’s April 2016 report, "Morningstar’s Active/Passive Barometer.” In that paper, Ben Johnson and Alex Bryan sorted actively run funds by their expense ratios. Those funds that placed in the cheapest quartile of their category, entering the year that the study began, were placed into a Lowest Cost group. Conversely, those funds that landed in the priciest quartile were tracked as Highest Cost.
The success rates were universally better for the Lowest Cost funds, usually by large amounts. For example, while only 22% of the large-value U.S. stock funds in the Highest Cost group beat their benchmarks over the next decade (Morningstar’s success rates tend to be higher than SPIVA’s because Morningstar’s time period is shorter, which means that more funds survive), 48% of the Lowest Cost funds beat that hurdle.

Using only Lowest Cost funds, and reducing the time horizon to 10 years, gives a rather different picture. In seven of the 12 categories that Morningstar evaluated, the actively managed funds either won the contest by scoring success rates of greater than 50% (mid-value U.S. stock, diversified emerging-markets stock, intermediate-term bond), or posted competitive results that exceeded 40%.

It’s no secret that actively managed funds have struggled, and are attracting few new assets. The Journal’s story—and the research behind it—showed why. Too many actively managed funds fold their hands, and most that stay around cannot overcome the performance drag of their expenses. Those things said, actively managed funds have performed better than the first glance indicates, particularly for those who own the cheapest funds.

The advice for active management to improve its fortunes is simple. First, take more care when opening and closing funds. Throwing investments against the wall to see what sticks, and shutting down those funds that don’t take hold, impresses nobody. That harms active management’s brand. Second, less is more! The lower the expense hurdle, the less high that management must jump.

And yes, that prescription sounds much like what Vanguard does with its active funds, which rarely (although occasionally) are shut down, and which invariably carry low expense ratios. The industry leader follows best industry practices, which its rivals could benefit from emulating. Imagine that.