One of the biggest debates and battles within the asset management industry continues to be passive versus active management. Over the last few years, passive seems to have won the battle, with a variety of studies and performance metrics showing that index funds tend to outperform funds actively managed by a person by a decent margin.
But the war is far from over. And it turns out, the debate shouldn’t be active versus passive, but cheap versus expensive.
Another study has recently come out suggesting that active management can and does win… if its fees are low enough. Thanks to the world of low-cost active ETFs, active may win the day just yet.
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Fees Matter
Vanguard founder Jack Bogle famously eschewed and trounced active management. Bogle argued that broad index funds not only offer plenty of diversification but, thanks to their lower costs, would continue to eat active’s lunch for the long haul. So far, Bogle has been right.
But Bogle’s assumptions may be changing toward active’s favor. That’s because costs for active management have started to drop in a big way. Thanks to exchanged traded funds (ETFs), lower costs of trading, and fund managers looking to compete, active management is finally having its day in the sun. A new study supports that fact.
Published by the CFA Institute, Fund Selection: Sense and Sensibility highlights how fees are a big driver in the passive versus active debate. The paper dove into European-based Undertakings for the Collective Investment in Transferable Securities (UCITS). In short, UCITS are funds that investors across the European Union can access no matter what nation they are in as they meet standards for the entire E.U. UCITS can be ETFs, mutual funds, etc. It’s just a label placed on the fund.
According to the paper, fees made all the difference. Looking at equity and fixed-income funds from 2008 to 2020, the study showed that in 35 different equity fund categories, active funds outperformed in 28 categories or 80% of the time. Moreover, the researchers found that the actively managed equity funds outperform passive funds by an average of 0.56% per year.
The kicker to the study? This was before fees were taken into account. After fees, active begins to underperform.
This was even more evident when the paper compared retail share classes with lower-fee institutional share classes. Here, after fees were included, a majority of institutional shares for nearly 25 categories (71%) still outperformed passive rivals.
The study echoes similar studies done with U.S.-based funds. Both Russell Investments and S&P Global highlighted comparable results with U.S. passive and active funds.
Active May Get the Upper Hand
The key to all of this is fees. Clearly, active management can and does outperform in several fund categories. Cost of these funds are is one factor that hurts overall performance. But that fact may finally be changing toward active’s favor.
For one thing, the passive explosion has forced active managers to compete on price. As investors have shifted to lower cost index funds, assets have bled from actively managed mutual funds. To keep assets under wraps, they’ve been forced to cut their fees. Secondly, trading costs for managers have also gone down, while new aspects like securities lending have allowed them to charge less while still keeping revenues strong.
Perhaps nothing has been more important for lower active management fees than the birth of ETFs. As active managers have embraced ETFs to house their strategies, the lower cost nature of the ETF has benefited investors.
The combination has helped drive fees lower. According to Morningstar, the asset-weighted fund fee across active funds stood at just 0.60% at the end of last year. That’s a 34% decline since the 1990s. The bulk of that decline has come in recent years as ETFs have taken over. From 2017 to 2021, the average expense ratio for active funds dropped 12%. Last year alone, this managed to help investors save more than $6.9 billion in fees.
The Bottom Line
The reality is active management isn’t as bad as it seems. It’s high fees have given it a bad rap. There are plenty of instances where active managers can and do deliver extra alpha for a portfolio, providing better income and outperformance of returns.
For investors, the latest study from the CFA Institute shows that the debate should focus on cheap versus expensive. When building a portfolio, it pays to examine all facets and fund varieties with a focus geared toward lowering expenses.
Thanks to the boom in active ETFs, using active portfolio management as one of those ingredients makes total sense.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.