Ben Johnson, CFA, is director of global ETF research for Morningstar and editor of Morningstar ETFInvestor, a monthly newsletter.Alex Bryan, CFA, is director of passive strategies research, North America for Morningstar.
The Active/Passive Barometer does not purport to settle the active-passive debate. Rather, it offers survivorship-bias-free data to inform this debate and help investors better assess their odds of succeeding with active managers across asset classes, time periods, and fee levels.
This barometer is unique in the pragmatic way it measures active-manager success. It compares active managers' returns against a composite made up of relevant passive index funds
(including exchange-traded funds). We believe this is a superior approach because it reflects the actual, net-of-fee performance of passive funds, rather than an index which isn't investable. To replicate the opportunity set an investor could have chosen from at the time, the Active/Passive Barometer assesses active funds based on their beginning-of-period
category classification. The report also tracks the asset-weighted and equal-weighted average returns for active and passive funds in each category, survivorship rates, and performance by fee quartile within each category.
In sum, the report should give investors a better sense of how investors in active and passive funds have actually fared across categories.
The Active/Passive Barometer finds that actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons, and experienced higher mortality rates (that is, many are merged or closed). In addition, the report finds that failure tends to be positively correlated with fees. (Higher-cost funds are more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success.) The data also suggest that investors have tended to pick better-performing funds, as the full category asset-weighted returns were generally higher than the equal-weighted returns. (This result does not hold within fee quartiles.)
The table below shows active funds' success rates by category. This is measured as the percentage of funds from the beginning of the sample period that went on to generate a return in excess of the equal-weighted average passive fund return over the period. To come up with a single return figure for funds with multiple share classes, we calculate the asset-weighted average return for each fund from its underlying share classes. The last two columns show the corresponding figures for the cheapest and most expensive quartile of funds, respectively, within each category.
There are a number of important patterns in the data above:
- Investors would have substantially improved their odds of success by favoring inexpensive funds, as evidenced by the higher success-ratios of the lowest-cost funds in all but one category.
- On the flip side of the coin, investors choosing funds from the highest-cost quartile of their respective categories reduced their chances of success in all cases.
- The large-value category is the most poignant example. The lowest-cost funds in this segment had a success rate that was 28 percentage points higher than the category average over the trailing 10 years through December 2014. Meanwhile, their high-cost peers had a dismal success rate of just 19% during this same span.
- Odds of success generally decreased over longer time periods, with value-oriented funds being the notable exception.
- Value managers had a higher long-term success rate than other types of active funds.
- The lowest-cost mid-value funds enjoyed the greatest long-term success rate (68%) and the highest-cost mid-blend funds the lowest (5%).
- Long-term success rates were generally higher among small-cap, mid-cap, foreign, and intermediate-term bond funds than U.S. large-cap funds.
The success rates do not take the magnitude of outperformance or underperformance into account, so they are not influenced by outliers. However, outliers can influence the asset-weighted and equal-weighted average category returns, which are reported in the table below. To calculate the equal-weighted returns, we first take the asset-weighted average share class returns for funds with multiple share classes, and then equal-weight the composite returns for each fund.
- Passive funds generated both higher asset- and equal-weighted average returns than their active counterparts in the large-blend, large-value, large-growth, mid-blend, mid-growth, small-blend, and small-growth categories.
- Active funds beat their passive counterparts on both an asset- and equal-weighted basis in the mid-value and foreign large-blend categories. They also generated higher asset-weighted returns in the diversified emerging-markets and intermediate-term bond categories.
These results represent a snapshot in time, and they may change. But this report effectively captures how an investor's original opportunity set has fared, and in doing so, it helps investors better gauge the performance of active and passively managed funds. Its focus on real index funds as a performance benchmark is an important step forward because it reflects an investor's experience better than an index. Finally, this research adds to the preponderance of evidence that fees matter. Investors can improve their odds of success with low-cost active funds. Expensive funds hurt those odds.
to see the full report.