Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How do active and passive funds stack up? Joining me to discuss some recent research on that topic is Ben Johnson. He is director of global ETF research for Morningstar.
Ben, thank you so much for being here.
Ben Johnson: Glad to be here, Christine.
Benz: Twice a year you put out what is called the Active/Passive Barometer. You have just concluded some data with an endpoint of the end of 2015 where you compare not just the performance but also the longevity of active funds relative to passive products. Let's talk about how you crunch the numbers there. What specific factors are you looking at?
Johnson: Our study is unique with respect to the way we benchmark active managers. Our benchmark in this case is actually a composite of the performance of all of the index mutual funds and exchange-traded funds in a given Morningstar Category. If, for example, we're looking at success rates amongst U.S. large-cap blend equity managers, we are including SPY, the SPDR S&P 500 fund, in that composite benchmark. We're including the Vanguard Total Stock Market Index fund in that composite benchmark.
This is important in that it gives us a more real sense of the actual outcomes that are being experienced by investors in active funds versus investors in passively managed funds. Many studies that look at exactly this same question tend to use an index, a single index, as the benchmark. The drawback there is that indices in and of themselves aren't directly investable. So, by using an index you're not able to capture all of the messy realities of trying to build a portfolio to track that index; fees, transaction costs, taxes in certain cases.
The other issue with that is that you can cherry-pick an index, and not all indexes are created equal. So our composite--our index is an amalgamation of all of the different indexes underlying all of these funds, all of these ETFs. The net result is a more real comparison of how active managers are faring on average relative to their index fund and ETF counterparts.
Benz: So are you asset-weighting at all? So, are you giving a greater weight to the bigger index funds and less of a weight to some of the small fry?
Johnson: So, we look at this through two separate lenses, two separate weighting schema. In calculating success rates we look at this on an equal-weighted basis. In calculating performance figures we look at both equal-weighted as well as asset-weighted performance across both actively managed funds and passively managed funds. What we found in both cases is that passively managed funds have on average, across virtually all categories, tended to outperform actively managed funds.
That said, what we've also seen is that the asset-weighted performance of active strategies across all categories has been greater than the equal-weighted performance. Now, what you can read into that is that investors choosing active funds have tended to on average select above-average active funds.
Benz: So, you mentioned success rate. I'd like to talk about what that is. What you're trying to capture there with that particular statistic?
Johnson: The way we define success rate for an active fund to be successful it has to have first survived the entire time period in question. We look back at the trailing one-, three-, five-, and 10-year periods and first and foremost, look to see which funds that existed at the beginning of that period, lived to see the end of that period.
The second hurdle for success is to have produced a return that was in excess of the return of that composite benchmark, again that amalgamation of the returns of all of the index funds and ETFs within these funds' respective Morningstar Categories. For example, if I was an active manager in the U.S. large-blend category and I survived the 10-year period that ended at the end of 2015, and I produced a return that was greater than that mashup of SPY and Vanguard Total Stock Market Index Fund, we would count that manager as having been successful.Read Full Transcript
Benz: So, in aggregate, the U.S. active equity funds don't look particularly good on this measure, but they look better in some areas than other. If I were looking at this data one thing I might come away with the conclusion of is that value is a place to go active--that you see the active value managers generally looking pretty good relative to that passive, as you call it, mashup. Let's talk about that. Is that a fair conclusion that value managers have done a better job adding value in that space than maybe growth or blend?
Johnson: I would say a more fair conclusion to draw from that data is that value has been, given the prevailing market environment, a place where your odds of success have been relatively greater. Now, I would attribute a lot of that to the fact that value as a style has been out of favor now for the better part of the decade. And when styles tend to suffer relative to other styles, say, broad-based blend exposure or a growth-oriented manager, what you see is that active managers tend to be more successful relative to their benchmarks or an amalgamation of their benchmarks in this case, by virtue of making out-of-style bets. So, you've seen U.S. large-cap value managers succeeding by virtue of straying to the right in the Morningstar Style Box and buying growthier names or going further down the market-capitalization ladder.
So, certainly, the data would seem to indicate that value managers are on average relatively more successful. I would put this cautionary note out there to say that a lot of that can be attributable to the fact that value as a style has not been all that stylish of late.
Benz: So, you might expect this to swing around, that at various points in time if growth goes deeply out of favor, those active growth managers who are not investing in pure growth names, could start to look a little smarter simply because the growth stocks have been out of style?
Johnson: That's absolutely the case. And it brings up an important point, which is that this is an inherently cyclical relationship. There are going to be periods of time where active managers are going to look absolutely terrible relative to their benchmarks. There are going to be periods of time where success rates will spike higher. It's going to be an inherently cyclical relationship. So we tend to place greater emphasis on the longer-term data than necessarily focusing in on the year-on-year variations. That's not to say that there aren't interesting things to suss out of that data, but there tends to be quite a bit of noise there.
Benz: So, more broadly speaking, even moving beyond sort of the category lens, is it safe to say that the 10-year period that you captured here, it encompasses a generally upward-trending market, at least over the past seven years? So, some of the active funds that might have more sort of a defensive characteristic, maybe they hold cash or even bonds or whatever they might do, all the while being primarily equity funds, those sorts of more defensive characteristics just haven't been rewarded during this particular time period.
Johnson: Absolutely. It hasn't paid to play defense for quite some time now, now that we're seven years into a bull market. So, it goes back to the point I had just been making in that there will be this cyclicality and especially, as certain periods roll off, say, the period following the bursting of the tech bubble, which made many value managers, in particular, go from looking like dunces to absolute rocket scientists. Those sorts of periods will sort of come into and fall out of these data sets.
Benz: Let's take a closer look at bond funds, and you picked up on what looks like a pretty interesting trend, which is that active bond fund managers were looking pretty smart there for a while. In the more recent past, their active bets haven't been rewarded. So, let's talk about that phenomenon and kind of what you think you're capturing there.
Johnson: If you look at the year-on-year variation in success rates amongst active managers in the intermediate-term bond category, you saw them slip pretty dramatically in 2015. And that in large part I believe reflects a reversal of a trend that had been working in many of those managers' favors, which is that credit had been performing quite well. Especially towards the end of 2015, that trend reversed. We saw some very high-profile flare-ups that were centered in the high-yield market but certainly the contagion spread to other asset classes. So that tailwind from credit, which has been a tailwind for a number of years now for many managers in the intermediate-term bond category, that generally speaking are being benchmarked to the [Barlays Capital Aggregate Index] and in our case, all of the index funds that track it, which in and of itself does not expand into certain more credit-risky areas of the marketplace. As that trend reversed, success rates deteriorated accordingly as those bets that had been winning bets soured somewhat, especially towards the back half of 2015.
Benz: So that's another good illustration of how these things can swing around pretty quickly based on what's in favor and based on the types of bets that active funds tend to make relative to their benchmarks.
Benz: Okay. Ben, fascinating research. I love this barometer. Thank you so much for being here to discuss it with us.
Johnson: Glad to be here. Thanks, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.