Actively Managed Funds Underperform, But Remain Viable

One in three of actively managed funds either performed at the same level or outperformed passively managed peer funds in 2017, according to a Morningstar study.

That’s a continuing trend – one that may well have investment advisors wondering if they should bother with pricier actively managed funds at all.

The Sub-headline from the Morningstar report titled ‘Success Rates Among Active Fund Managers Tumbled In The First Half Of 2018’ said it all.

Two takeaways from the semi-annual Morningstar report, which tracks 4,500 active and passive U.S. funds, pour more gasoline on the active management bonfire.

• The one-year success rate among active U.S. stock-pickers declined relative to year-end. Just 36 percent of active managers categorized in one of the nine segments of the Morningstar Style Box both survived and outperformed their average passive peer over the past 12 months. In 2017, 43 percent of active managers achieved this feat.
• When compared with mid-year 2017 figures, active funds’ success rates dropped in 15 of the 19 categories that were examined.
• Stylistic headwinds and tailwinds explain some of the fluctuations in active-fund success. Also, active managers tend to have difficulty keeping up with index funds in strong markets, as many will keep cash on hand to make opportunistic investments or meet redemptions. The resulting cash drag can weigh on their performance.

Still In Play

Market experts aren’t quick to criticize actively-managed funds.

James Comblo, money manager and chief compliance officer at FSC Wealth Advisors, LLC, in Wappingers Falls, N.Y. said there are times when active management is the better option for investors.

To Comblo, timing really is everything when it comes to choosing active and passive funds.

“In times of low volatility like we saw in 2017 where the market just seems to march higher and takes everything in stride, we like to use passive funds,” he said. “It makes sense to use a lower cost vehicle when ‘stock picking’ isn’t the priority because the entire market seems to be going higher. In these cases, we like ETFs.”

Vice versa, when investors enter highly volatile periods in the market like earlier in 2018, active management or “stock picking” becomes extremely important.

“Volatility showed in the performance of various funds,” Comblo said. “This happens due to investor psychology, which hasn’t changed much in 100 years.”

Comblo says that the ongoing debate of passive versus active really isn’t the best way to frame the issue.

“We don’t have an opinion on passive against active, we just want to use whichever is the better option at a given time,” he said. “We believe actively managed funds will be around for the foreseeable future, albeit with lower assets than what is considered normal, historically.”

That balanced view seems to be the prevailing sentiment among money managers, despite periodic episodes of underperformance on the part of actively managed funds.

Mark McKaig, owner of Centurion Wealth Management, in McLean, Va. said, “It’s true, the statistics don’t lie. “Many active managers don’t beat their benchmark and investors, both individual and institutional, are voting with their wallets and moving funds out of active and into passive funds.”

Despite active funds falling out of favor, McKaig continues to believe that there is room for both and advantages to having both passive and active models in a portfolio.

“We build portfolios that include both active and passive investments,” he said. “We are mostly passive in our equity allocation. With the exception of some international and small-cap positions, we believe that the performance, low costs and low turnover provided by index investing are additive to our portfolios.”

On the other hand, McKaig said he generally allocates his firm’s fixed income investments to active managers. “We think it’s important to actively manage fixed income in a rising-interest-rate environment and look to active fixed income managers to employ strategies to help manage that risk,” he said.

Go Low?

One fly in the ointment for actively-managed funds, which are more costly to manage:

Robert Johnson, professor of finance, Heider College of Business, at Creighton University said, “The vast majority of investors would be better served by simply investing to low cost index funds.”

Just like the positive influence of compounding increases with time, the influence of fees increases over time, Johnson said. “Fees compound over time just like investment returns,” he said. “Jack Bogle, founder of Vanguard has referred to this phenomenon as ‘the tyranny of compounding costs’.”

For example, an investor has an account that grows in value by 8 percent annually before fees, while that investor pays one percent of assets under management to have that account managed. “In effect, you earn effectively 7 percent compounded annually,” Johnson said. “If you had $1 million to start with, in 20 years you would have $3.87 million — not bad. But, if you didn’t pay one percent annually in fees, you would have accumulated $4.66 million. That seemingly innocuous one percent annual fee cost you $790,000.”

Not Down For The Count Yet

The active versus passive debate rolls on, at a time when actively managed funds are largely underperforming. That’s a bad look for the active side, but it seems money managers aren’t giving them up – yet.

Dr. Stephan Unger, assistant professor of economics at St. Anselm College said, “If the underlying elements of both funds are highly correlated, then it is clear that a passively managed fund outperforms an actively managed fund, simply due to its lower cost structure, such as lower management fees. For uncorrelated assets, actively managed funds are only useful if volatility increases, as they might outperform passively managed funds in turbulent times.”

The bottom line is the question about an investor’s expectation about the future development of markets, Unger said.

“If an investor thinks that the upward trend in markets will continue for a longer time, then passively managed peer funds are sufficient,” he said. “If an investor expects turbulent times, the markup on actively managed funds might pay off.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at [email protected]

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