There’s often a strong argument for passive funds - not only does it keep investing simple, but it can also keep costs low.
Active funds on the other hand have had a bit of tough time in challenging market conditions with many seeing their returns dip and investors asking if the high fees associated with them are in fact at all justified.
But in recent weeks, you may have noticed a few articles in recent weeks suggesting a revival in fortunes for active fund management. “It’s Official: Active Management Is Back” roared one headline, “Active Management Shines Again” another. But is either of these statements actually true?
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We have, of course, been here many times before. It’s well documented that active funds have largely failed to outshine their passive rivals for several decades, and particularly since the global financial crisis. We’ve seen repeated predictions over the years that active was about to turn the corner, but none has yet materialised.
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So why the cause for optimism now? It’s mainly down to Morningstar’s latest semi-annual Active/ Passive Barometer report. Out of 8,212 actively managed mutual funds and ETFs in the US, the report states, 57% survived and beat their average passive counterpart over the 12-month period to the end of June. That represents a significant improvement on the 43% figure for the calendar year 2022. The best performers were small-cap managers, 65% beat their average passive peers.
The most impressive turnaround came in the bond fund category. Around 55% of active bond managers survived and beat the passive average, compared to just 30% in 2022. The performance of active corporate-bond managers improved dramatically, with a success rate of 60% success rate, up from 34% last year.
Are active fund managers becoming popular again?
These are all encouraging signs, but, for a number of reasons, active managers shouldn’t be cracking open the champagne just yet.
For a start, another active management scorecard, the SPIVA scorecard from S&P Dow Jones Indices, which uses a slightly different methodology to Morningstar’s, paints a much less rosy picture. The Mid-Year SPIVA report for the US shows that, in the year to the end of June, 60 percent of large-cap managers underperformed the S&P 500 index.
Another caveat is that this particular Morningstar report only covers US-domiciled funds. In the rest of the world, active funds continue to struggle. The 2023 Active/Passive Barometer for Europe, for example, shows that although 2022 presented active managers with the perfect opportunity to demonstrate their worth they mainly failed to do so.
On average, only 30% of active funds in the 43 equity categories Morningstar analysed across Europe survived and outperformed their passive peers in the calendar year. In only three categories did active managers achieve a success rate of more than 50 percent.
What about UK active fund managers?
We often hear that the UK is an exception, but are active managers domiciled here performing any better than their peers overseas? The answer is a resounding ‘no’.
The SPIVA Europe scorecard, unlike Morningstar’s, provides a direct comparison between managers in different European countries. The Mid-Year report has not yet been published, but the most recent report showed that a whopping 92% of UK-domiciled large-cap funds and 97% of mid-cap funds underperformed their benchmarks in 2022 — the worst performance by fund managers in any country that SPIVA has ever recorded.
Of course, what these reports are highlighting is past performance. What matters to investors is how funds perform in the future. So what clues are there as to how active managers will fare over the next year or two?
The good news for active managers is that current conditions appear to favour them. That’s because, in theory, there should be richer pickings for stockpickers when correlations are low (in other words, when stocks tend not go up and down in price together) and dispersion is high (that is, when the gap between the best- and worst-performing stocks is elevated).
The bad news is that, in practice, even in low-correlation and high-dispersion environments like the one we are now, active managers find it very hard to outperform.
Another crumb of comfort for active management, according to the investment consultancy firm Mercer is that the long period of very low interest rates has finally ended. In a new report entitled After the perfect storm – active management recovers, Mercer claims that low rates caused distortions in stock valuations which benefited passive funds.
“Levering-up balance sheets to pay dividends and repurchase company shares,” the report says, “fuelled… the appreciation and concentration in stock markets, especially in US large caps, which created further challenges for active management.”
The return of higher interest rates has reduced these imbalances, the authors claim. This, they say, “should lead to increased dispersion in stock returns, thereby likely creating a supportive environment for active management.”
Whether or not this prediction proves correct, it has to be said that we’ve heard many excuses for the poor performance of active funds in the past. It was long suggested, for example, that Quantitative Easing made stockpickers’ job especially challenging and that they were likely to reassert themselves when severe volatility returned. QE has now ended, and we’ve seen enormous volatility caused by the pandemic and, to a lesser extent, the war in Ukraine, and yet active performance has continued to disappoint.
The bottom line is that there will always be periods when active management appears to be on the ascendant. Remember, too, that there are many vested interests who benefit from active management — not just fund houses and their shareholders but, for instance, many consultants, stock analysts and brokers as well. They will inevitably argue that investing in active funds is still a good idea.
But the long-term record of active management is highly discouraging, and, just as one swallow doesn’t make a summer, one set of data doesn’t mean that active’s struggles are over.
So, as the FT’s Robin Wigglesworth put it the other day, “can we stop running headlines about active management being back on the rare occasions that a short-term arbitrary snapshot of time shows that they have done a bit less badly than usual?”
