While Standard & Poor’s Indices Versus Active (SPIVA) persistence scorecard measures the performance of active managers compared to a benchmark index, the Active/Passive Barometer from Morningstar measures the performance of domestic active funds against their passive peers—live index fund returns net of fees and expenses—within their respective categories.
The Morningstar Report: Fees Matter
Unfortunately for faithful adherents to active management, Morningstar’s June 2015 report, which covered the 10-year period ending in 2014, found that active funds generally underperformed their passive counterparts, especially over longer time horizons, and experienced high mortality rates.
In addition, and there’s no surprise here either, the firm’s research team found that failure tended to be positively correlated with fees (higher cost funds were more likely to underperform, be shuttered, or merged away, while lower cost funds were more likely to survive and enjoy greater odds of success). Morningstar concluded: “Fees matter. They are one of the only reliable predictors of success.”
Another interesting, and related, finding was that investors tended to select better performing funds, evidenced by the fact that full-category, asset-weighted returns were generally higher than equal-weighted returns. In other words, investors seem to be learning that fees do matter. However, researchers also found that this result didn’t hold within fee quartiles. Thus, investors were benefiting simply because they tended to choose funds with relatively lower fees.
Active vs. Passive Success
Including nine domestic styles and two international styles (developed and emerging markets), the 10-year success rate for active funds saw a majority of them outperforming in just a single category, U.S. mid-cap value. And that was only by a slim 54% majority.
Success rates in other styles ranged from as low as 14% for U.S. mid-cap blend funds to as high as 48% for U.S. small value funds. Aside from U.S. mid-cap value and U.S. small-cap value, no other equity asset class showed a success rate of greater than 41%. And in the supposedly inefficient asset class of emerging markets, the success rate was just 37%. Even if you limited your choices to the lowest expense quartile, the success rate of active emerging-market funds was still just 47%. I’d add that in another supposedly inefficient asset class, U.S. small-cap growth, the success rate was only 24%.
With that said, it’s worth noting that success rates were higher for funds in the lowest quartile of expenses, as we should expect. When using only funds in the lowest expense quartile, a majority of active funds outperformed in four of the 11 asset classes, with the success rate ranging from about 22% in U.S. mid-cap blend to about 66% in U.S. large-cap value. In emerging markets, however, a majority of the active funds in the lowest cost quartile underperformed.
Another important highlight from the report is that Morningstar found that just 50% of the actively managed U.S. large-blend funds that existed as of December 31, 2004 managed to survive the entire 10-year period. For large-cap growth and large-cap value funds, the figures were slightly better at 52% and 60%, respectively. The failure rates were somewhat lower in the other asset classes.
Finally, it’s important to keep in mind the caveat that the data in the report is all based on pre-tax returns. Given the generally greater turnover of actively managed funds, failure rates would surely have been much higher for taxable investors. It’s often the case that the largest expense incurred by actively managed funds is the cost of taxes.
The Bottom Line
This reality led active fund manager Ted Aronson of AJO Partners to declare: “None of my clients are taxable. Because, once you introduce taxes…active management probably has an insurmountable hurdle. We have been asked to run taxable money—and declined. The costs of our active strategies are high enough without paying Uncle Sam.”
The bottom line remains the same: as Charles Ellis wrote in his 1998 book Winning the Loser’s Game, active management is a loser’s game. And like all losers’ games, the surest way to win is not to play.
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