The Active Manager Comeback (or Not?)

Are active mutual fund managers beating passive funds? Should you own only passive index funds? What is the best way to invest and gain exposure to stock and bond markets?

Our work suggests the majority of investment assets should be managed passively to maximize results and reduce both costs and taxes. However, active management may be useful in a few, less mature asset classes. We lay out our perspective below.

According to the Dow Jones SPIVA scorecards, 85% of U.S. stock funds have underperformed their benchmarks over the last 5 years. Not 51%, not 60%...85%. It’s not even close.

Morningstar’s Active Passive Barometer is a similar study and shows only 43% of actively managed funds outperformed in 2022.  In large cap, only 10% of actively managed funds survived the last decade and outperformed.

Yet, over the last 12 months there has been a lot of discussion about the “return of active management” in the media. Barron’s published an article on a return to the “golden age of active management.” Many fund managers commented last year that in highly volatile markets, active management would demonstrate its true value.

It is true that some large cap stock fund managers did slightly better than usual against their benchmarks in 2022. Depending on the style, according to Morningstar, between 5% and 9% more managers beat their benchmarks in 2022. For large cap growth, value and blended strategies, that means still only 37%, 47% and 54% outperformed respectively.  In my book being less bad isn’t an investment case.

Will the recent performance hot streak continue?

For the funds that were in the top 25% best performing funds from June of 2019 through June of 2020, none of these funds repeated the outperformance over the next 12 months. So even if you find a U.S. stock fund that outperforms over a short period of time, it is unlikely to repeat its performance going forward. That’s why the number of decade long outperformers is so low at only 10%.

The research we laid out above suggests little value for actively managed U.S. large cap stock funds. The results are similar for small cap stocks and core bond funds. Active management provides little value if your goal is to meet or exceed a benchmark.

Are actively Managed Funds always bad?

No, but the data suggest that you should be very picky about using active investment managers. There are a limited number of asset classes where passive management is challenging or where active management may still provide more consistent outperformance.

Our work on international stocks shows that a much higher percentage of managers outperform over multi-year periods. Our study looks at the performance of investor and institutional share classes of all U.S. based diversified emerging market mutual funds. We compare the total return performance against the iShares MSCI Emerging Markets ETF, which is a core passive index utilized in emerging market investing. We found that 51%, 55%, 67% and 73% of funds outperformed over the past year, 3-year, 5-year and 10-year time periods. Morningstar’s work also shows a higher percentage of actively managed international funds outperforming over long timer periods. In our view, low cost active management in emerging market stocks makes sense.

Active management is generally required in private asset classes such as private equity and private real estate. From 2002 through mid-2022, the median private equity buy-out fund outperformed the S&P 500 by 6.8% each year. Venture Capital funds outperformed the Russell 2000 index by 3.8% each year. In these asset classes, top quartile returns, or the top 25% of funds, drive even more outperformance against passive investments. Thus active management is probably worth the additional expense when allocating to private assets.

A word of caution about private fund managers: just because active management is worthwhile, does not mean your portfolio should have expensive active managers. The top 25% of managers drive most of the outperformance. The remainder tend to demonstrate performance in-line with or below their benchmark index. So if you cannot access a top manager, you should consider indexing.

In the fixed income portion of portfolios, some investments do not have passive options. In 2022, we used high yield floating rate bank loans to hedge against rising interest rates while earning portfolio income. There is not a passive index to match this exposure. There are other corners of the fixed income market where indexes have not been created or do not work for technical and liquidity reasons.

So there are a limited number of places where active management makes sense, but it’s not where the majority of the funds are invested, which is in large cap stocks.

So how should I Invest?

We suggest focusing on asset allocation. Roger Ibbotson’s 2010 article, “The Importance of Asset Allocation,” compiles years of investment research on investment returns and concludes that market exposure and asset allocation are responsible for the vast majority of differential returns over the long-term. Said differently, investors should focus on being invested in the market and on owning the right mix of asset classes (stocks, bonds, real estate, gold etc.) to drive long-term investment returns in accordance with their risk tolerance. Active management only helps influence a small percentage of the total return over time.

In conclusion, our view is that historical data suggests that using passive management in the majority of equity and bond portfolios is appropriate. However, it is important to recognize areas where a passive approach is not possible or is less desirable and utilize active managers in these areas. Focus on asset allocation, not picking active managers. If you look at your portfolio, and it is full of actively managed mutual funds, you may need to evaluate whether those funds are driving positive performance results after fees.