Are mutual fund investors better served by investing in actively or passively managed mutual funds and ETFs? Short answer: depending on one’s individual circumstances, both types of funds can play a positive role in a well-diversified investment portfolio. Diversification among active and passive strategies can be additive to a portfolio’s returns, reduce overall expenses, and help mitigate risk in different market cycles.
Are mutual fund investors better served by investing in actively or passively managed mutual funds and ETFs? Short answer: depending on one’s individual circumstances, both types of funds can play a positive role in a well-diversified investment portfolio. Diversification among active and passive strategies can be additive to a portfolio’s returns, reduce overall expenses, and help mitigate risk in different market cycles. Passively managed mutual funds (index funds) and ETFs (exchange traded funds) are designed to mimic the returns of a particular index. A passive manager typically buys all of the components that comprise an index. The manager of the Vanguard S&P 500 Index Fund, for example, invests proportionately (relative to market capitalization) in all 500 stocks in the S&P 500 index in order to achieve returns in line with the leading benchmark for U.S. large cap equities.
Performance of an index fund is measured in part by “tracking error,” which looks at how much the returns of the fund veer from the returns of the index it is designed to track. Some index funds track their benchmarks more closely than others. Because fund expenses are one component of tracking error, lower expenses usually reduce tracking error.
An active fund manager, on the other hand, does not buy shares of all the components of a given index, rather he/she selects individual stocks or bonds based on a defined investment strategy. Active fund managers are stock and bond pickers. Some managers look for companies whose growth will outpace other companies in that same asset class. Other managers may look for companies which are undervalued (selling at a discount to their intrinsic value). Other strategies may be based on the manager’s expectations of the relative performance of different economic sectors.
Actively managed funds typically have a higher expense ratio than passively managed funds because active management involves more work and research, thereby increasing the manager’s cost. At the end of the day, an active manager’s performance will be judged by how well they performed—net of fees—compared to their benchmark. S&P Dow Jones Indices publishes an annual report on the relative outperformance or underperformance of actively managed funds against their respective benchmarks over a rolling 10-year investment horizon. (See SPIVA U.S. Score Card Year-End 2014, S&P Dow Jones Indices, McGraw Hill Financial.) The 10-year rolling study as of the end of 2014 reports that actively managed funds on the whole underperformed their benchmarks by a substantial margin over all time periods the last 10 years:
• The S&P 500® had its third straight year of doubledigit gains in 2014, returning 13.69% (returns were 32.39% in 2013 and 16% in 2012). Based on data as of Dec. 31, 2014, 86.44% of large-cap fund managers underperformed the benchmark over a one-year period. This figure is equally unfavorable when viewed over longer-term investment horizons. Over 5- and 10-year periods, respectively, 88.65% and 82.07% of large-cap managers failed to deliver incremental returns over the benchmark.
• The returns of 66.23% of mid-cap managers and 72.92% of small-cap managers lagged those of the S&P MidCap 400® and the S&P SmallCap 600®, respectively, on a one-year basis. Similar to the results in the large-cap space, the overwhelming majority of midand small-cap fund managers underperformed their benchmarks over the longer-term horizons as well.
The big takeaway in the SPIVA report is that on the whole, only 25% – 30% of active managers “beat” their respective indices over 5-10 year investment cycles (and even fewer over shorter time horizons). With the odds stacked against them, the average investor has a better chance statistically of achieving the average return of an asset category by investing in an index fund.
The first chart on the following page shows how the Vanguard S&P 500 Index Fund (considered one of the leading passively managed funds) has performed on a rolling 36-month basis relative to actively managed funds in the large cap category over the last 34 years. The chart is divided horizontally into quartiles. If the black dot is in the top quartile, it means that the passively managed fund did better than 75% or more of the actively managed funds on a rolling 3-year basis. If the black dot is in the third quartile (falling between the horizontal lines marked 50%-75%), it means that the passive fund’s performance was below more than half of the actively managed funds in this category. What is interesting is that over a longer period of time (more than 30 years), it’s easy to see that in some market cycles the passive strategy outperformed most active strategies, and in other market cycles, the passive strategy underperformed most active strategies.
To demonstrate how index investing can deliver diversification benefits relative to active investing, the chart above shows the rolling 36 month returns of a group of 4 highly-rated actively managed funds over the last 7 years (which thus measures performance since 2005). All four of these funds are either 4- or 5- star rated by Morningstar, which means they fall within roughly the top one-third of all mutual funds in their category in terms of risk-adjusted relative performance. Three of the funds have delivered better annualized performance over the last 10 years than the index (beating the index on an annualized basis by 1.12% to 2.66% per year). As good as these managers are relative to their peers, the chart demonstrates that the active funds outperformed the index on a rolling 3-year basis in some periods, and underperformed on a relative basis in other periods.
What lessons can we take from all of this information? First, finding good active managers is hard to do. Statistically speaking, only a handful outperform their benchmark on a rolling 10-year basis (and less over shorter time periods). Second, even “top managers” won’t outperform in every given period. One study examined the periodic performance of managers who outperformed their respective indices by one percentage point or more on an annualized basis over a 10-year period with less volatility than their benchmark. Of this group of truly outstanding fund managers, 85% had at least one three-year period in which they underperformed their style benchmark, and on average they underperformed during six separate rolling three-year periods. Of these top managers, 81% fell to below-average in at least one three-year period and remained there for almost 4 quarters. (See The Truth About Top-Performing Mutual Fund Managers by Aaron Reynolds, July 2011.)
Chasing historical performance of either an index or an active manager is counter-productive. It takes a rigorous research and due diligence process to uncover the quality and processes of the management team, the strength and consistency of the investment strategy, and other factors that give an investor confidence that the manager is likely to outperform his/her benchmark on an annualized basis over different market cycles.
Even when an investor has identified excellent active managers, it is unreasonable to expect that the manager will consistently outperform his or her benchmark. To outperform an index by a considerable margin, a fund has to be very different from that index. It is therefore inevitable that such a fund will also have periods of significant underperformance. We believe that passive funds play an important role in an actively managed diversified portfolio. Active and passive strategies will perform differently on a relative basis during different market cycles, and mutual fund portfolios can benefit from both. Exposure to passive management reduces overall expenses and is a hedge against periods of underperformance by active strategies. Exposure to good active managers, and diversification among the style of active managers, can offer both “alpha” as well as defensive benefits to a portfolio.