It is a well-known fact that few active managers can consistently beat the market, especially over long-term periods. In fact, Morningstar calculated that 2016 proved to be a particularly difficult year with only about 26% of active U.S. equity funds beating their composite passive benchmark, versus 41% in 2015.
Morningstar also notes that long-term success rates were generally higher among U.S. small cap, U.S. mid cap, and foreign stocks, but lowest among U.S. large cap funds. This can be explained by the fact that large U.S. stocks are the most widely followed securities in the world making pricing inefficiencies harder to come by. At year-end 2016, 63.7% of assets were actively managed, however, this is declining rapidly, down from 72% just three years ago. Despite better success rates for some asset categories, all have seen outflows from active to passive, with some categories worse than others. Yet, is the grass greener on the other side?
Investors are plowing money into passively-managed funds given extremely low expense ratios, simplicity and transparency, tax efficient status, and subpar management performance for many actively-managed funds. However, it is not as simple as it may seem. Passively-managed funds have no regard for fundamental information, valuations, or business models as the funds buy stocks in the same proportion as the indexes that they track. Passive funds are clearly an easy way to bet on any market without overweighting the wrong stocks, but the funds cannot raise cash or diversify away investment risks. If a sector or industry gets too expensive, passive funds are not set up to exit these. Many theorize that it will take a market correction for flows to reverse as active managers might be able to control the damage on the way down. Only time will tell.
Yes, it is true that actively-managed funds generally have higher fees and trading costs, and because of the far fewer names owned in active funds, these funds carry company specific risks. However, there are positives to owning active funds. These funds can control risk by limiting exposures to sectors, industries, and companies and typically apply quality standards when selecting stocks. For the year-to-date period through July 31, 2017, JP Morgan pointed out that 53% of active managers are outperforming their respective indexes, up from 32% over the same period in 2016.
Active and passive strategies unquestionably offer both advantages and disadvantages. If active management is selected, choose managers that offer lower-cost funds. The funds should have well-conceived philosophies with reliable and repeatable investment processes backed by a tenured team of portfolio managers and analysts who have the tools in place to yield strong performance in the long run.
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