Trader Talk

Former hedge fund manager Nelson Saeirs’ paintings visually represent the volatility trading algorithms he used on Wall Street. This one is titled, “The VIX over 40.” A reading in the VIX volatility index over 40 has historically preceded huge market losses
Source: Nelson Saiers

If there ever was a year active management should have outperformed passive, indexed strategies, 2020 and the first half of 2021 should have been it.

For decades, active managers have claimed that in boring markets, don’t expect them to outperform. When things change fast, however, when there are rapid changes in the economic outlook and high volatility in the markets, active managers who can make quick decisions will crush their passive competitors.

They had a chance during 2020 and 2021, one of the most volatile markets in decades.

Two recent reports by Morningstar and S&P Global come to the same conclusions: It didn’t pan out.

Of the nearly 3,000 active funds Morningstar analyzed, only 47% survived and outperformed their average passive counterpart in the 12 months through June 2021.

“Roughly half beat, and half lagged. It was what you would expect from a coin flip,” said Ben Johnson, director of global ETF research and the author of the Morningstar report.

The Morningstar Active/Passive Barometer is a semiannual report that measures the performance of U.S. active funds against passive peers. It accounts for two factors when assessing fund returns: the cost of fees, and survivorship bias.

It’s critical to account for survivorship bias. About 40% of all large-cap funds fail over a 10-year period. That’s because many fund managers are terrible stock pickers, and their funds are closed.

“We include all funds, including those that didn’t survive,” Johnson told me. “There was real money trapped in those funds.”

A recent report from S&P Dow Jones Indices came to a similar conclusion: Over the 12-month period ending June 30th, 58% of large-cap funds, 76% of mid-cap funds, and 78% of small-cap funds trailed the S&P 500, S&P MidCap 400, and S&P SmallCap 600, respectively.

Long-term performance is even worse

The performance of active managers gets much, much worse when you look at longer time horizons: over a 10-year period, only 25% of all active funds beat their passive counterparts, according to the Morningstar report.

It’s even worse among large-cap equity funds, which are what most investors hold: Only 11% of actively managed large-cap funds outperformed their passive peers over 10 years.

The conclusion: fund managers may get a hot hand for one, two, or three years, but it rarely lasts. Over longer time horizons, even those with short-term “hot hands” fail.

Johnson’s conclusion: “There’s little merit to the notion that active funds are more capable of navigating market volatility than their passive counterparts.”

How could stock pickers be so wrong?

It has been known since the 1930s that the vast majority of stock pickers do not outperform the market. However, a comprehensive, reliable database on stock prices was not available until the early 1960s.

Once investigators began sorting through the evidence, most active traders came up short.

The evidence got stronger into the 1970s and 1980s when books like Burton Malkiel’s “A Random Walk Down Wall Street” and Charles Ellis’ “Winning the Loser’s Game” chronicled the underperformance of active fund managers.

In a now-famous passage from the first (1973) edition of “A Random Walk Down Wall Street,” Malkiel said, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”

Why can’t active managers outperform?

The problem is multifaceted. First, active trading involved market timing, and the evidence is that market timing is very difficult to achieve.

“When you are trying to time the markets, you have to be right twice: going in, and going out,” Larry Swedroe, director of research for Buckingham Strategic Wealth, told me.

Second, even if an active manager managed to outperform, high fees and trading commissions eat into whatever excess performance —alpha they are able to generate.

Finally, performance is getting worse because active fund managers are competing mostly against professionals. “The pool of victims has shrunk dramatically,” Swedroe said. “Prior to World War II, most stocks were owned by individuals. Today, only a small percentage of trading is done by individuals. The vast majority of trading is done by institutions, and it’s very hard to compete against them.”

Active bond fund managers fared better

While results for stock pickers were dismal, long-term success rates were generally higher among foreign-stock, real estate, and bond funds.

Why would active stock pickers have a better shot at those sectors?

“These are areas of the market that are less picked over, there are fewer participants” Johnson said.

For example, nearly 85% of active funds in the intermediate core bond category outperformed their passive peers in the year through June 2020. “The post-COVID-crisis rebound in credit markets has been favorable for active funds in the category, which tend to take more credit risk than their indexed peers,” Johnson said.

Over time, however, even active bond managers lose their touch: after 10 years, only 27% of those bond managers outperformed passive indexes.

Choose low-cost active managers over high-cost

One thing is clear from the Morningstar report: If you are going to pick an active manager, it’s better to look for the lowest-priced one.

The cheapest funds succeeded about twice as often as the priciest ones (a 35% success rate versus a 17% success rate) over the 10-year period ended June 30, 2021. The cheaper funds also had a higher survival rate: 66% of the cheapest funds survived, whereas 59% of the most expensive did so.

“What we find in almost every case, is that cheaper actively managed funds do better than more expensive funds.”

“If you can find a well-run active manager that charges the same as a passive fund, you might want to consider that active fund,” Swedroe told me. “But that is very, very hard to find.”