Active management is enjoying something of a renaissance in 2018, as the much-maligned and increasingly abandoned investment strategy posts modest improvements in performance, but data continue to show it is a pricier and less effective way of getting exposure to stocks.
By and large, investors have left actively managed strategies in favor of passive ones, which analysts say is by far the best path for portfolio construction. Over the past year, according to Morningstar Direct, $211.8 billion has flowed out of actively managed U.S. stock funds, while passive funds have seen inflows of nearly $200 billion.
In an actively managed portfolio, a manager or team will individually select the securities held, and at what weight. This is in contrast to passive strategies, which simply “own the market” by holding the same securities at the same weight as an underlying index like the S&P 500 SPX, +0.15% While passive portfolios will never perform worse than the overall market (excluding fees, although passive fees tend to be extremely low), they will also never outperform; they will hold all the market winners, but also have no choice but to also own the worst-performing stocks.
The argument behind active management is that through individual security selection, a manager will be able to generate alpha, or do better than the benchmark. However, this basically never works out in practice, according to Morningstar.
Jeffrey Ptak, global director of manager research for Morningstar, looked at more than 3,300 funds that have a record of at least five years (another 1,500 or so didn’t last that long.). Of those hundreds of funds, just 15—a mere 0.5% of the total—placed in the second quartile of their peer group in at least three of every four calendar years. However, seven of those funds were index funds, meaning that only eight actively managed funds, of 3,343 total, could boast relatively consistent outperformance relative to a benchmark.
“Investors hunting for such funds are largely wasting their time,” Ptak wrote. Over the long term, the pool of outperformers “shrinks to almost nothing.”
He added, “Speaking of nothing, of the 2,158 active U.S. stock funds that lived through at least 10 calendar years, not a single fund landed in the second-quartile of its peer group in at least three quarters of the years.” The following chart shows how many such funds exist over time.
An investor who had been in the top-performing actively managed fund over the long term would’ve seen bigger gains than a passive investor. But “do [investors] have what it takes to identify and stick with long-term successful funds that wheeze and lurch, confound, and frustrate over the short term?” Ptak wrote (emphasis in original). “Most don’t and therefore should index.”