Are Active Funds Better in Less-Efficient Markets?

Alex Bryan: Thank you for having me.

Benz: Alex, I often hear this from investment advisers and from individual investors. They say, well, I use index funds and ETFs in those really efficient market segments like the large-cap blend category, whereas I use active funds in some of the areas I perceive to be less efficient like small-caps. Does that make sense to you as sort of a strategy as a way to approach this decision about what types of vehicles to use for various market segments?

Bryan: Well, it's certainly an understandable argument. So the argument is that more efficient markets like large-cap U.S. stocks tend to be very efficient in terms of informational efficiencies. There's a lot of competition for superior returns in that segment of the market, and it's very difficult to get an informational edge.

Therefore, even if you spend a lot of time picking good managers, it can be hard to identify ones that are going to offer much of the benefit from some of their insights. And the thinking goes that maybe in some less efficient area of the market like emerging-markets or like small-cap stocks, there could be a bigger advantage of selecting a manager that has an informational edge.

The problem with that argument is that active management regardless of how efficient or inefficient a market is, is still a zero-sum game. In aggregate, active managers or active investors define the market. So an index is simply replicating what active investors are already holding, and it's doing that at a lower cost than the average actively managed dollar. Therefore, net of fees, indexing should come out ahead. That's true of regardless of how efficient or inefficient the market is.

Benz: So, the active/passive barometer that the manager research team puts out attempts to gauge this issue kind of looking category-by-category. You look at success rates within various categories of certain types of funds. Let's discuss how you define success rate before we go any further.

Bryan: Sure. So, the success rate looks at all of the actively managed strategies that were available in each Morningstar category at the beginning of a time period, let's say, 10 years, and it looks at how many of those strategies went on to outperform their index peers over that time horizon. So they had to survive, and they had to outperform. So we looked at the percentage of funds that actually accomplished that as a percent of all the funds that started out. So in most cases – I think in almost every case – the success rates were below 50%.

Benz: And in some cases, it was really striking, large blend being one where I think it was like a 17% success rate for those active managers?

Bryan: Absolutely. Now those success rates were a little bit higher among the lowest cost active managers but they were still below 50% in most cases. So that definitely indicates the challenge that's ahead of investors who are trying to select winning active managers.

Benz: So in your piece in Morningstar ETF Investor you looked at some of the factors that would determine, would influence investors' success or failure with active funds versus indexed products. One of the biggies is cost, obviously, that if you are paying more for an active fund, you are effectively stacking the deck against yourself. Let's talk about that issue a little bit.

Bryan: Sure. So the cost differential is the hurdle that active managers have to overcome year in and year out just to provide the same returns net of fees. So, let's say, the average active manager in the large-blend category charges somewhere in the upper, I believe, 80 basis points-range, and you can get a low-cost index fund for 5 basis points.

So that means that the average active manager has to outperform the index by somewhere in the range of the mid-70 basis points range just to break even net of fees. And that's a tall hurdle, and that's tough to do year in and year out. That's one of the benefits of going with a low-cost index fund or even with a low-cost actively managed fund.

Benz: Well, that I thought was an interesting point in your piece that it is possible to find very low-cost products and if you are looking for an active product, that's really how you should be winnowing down the universe.

Bryan: It's certainly a good starting point. The lower the cost hurdle to overcome, the easier it is for active managers to add value.

Benz: You also note in the research, though, that cost is less important as a determinant of success or failure with active versus index. If the index that funds are tracking is not all that representative of the pond that active managers are fishing in. Let's talk about that because I think the discussion of the intermediate-term bond group relative to the Barclays Aggregate Index, which you discuss in the piece, I think, that's a really good illustration.

Bryan: Sure. So, if active managers look different than the composition of the benchmark of an index fund, their performance can diverge over long periods of time and then the cost advantage of the index fund maybe a less reliable indicator of its ability to outperform. So the intermediate-term bond category is a great example of that because, let's take the Barclays Aggregate Bond Index, for example. That's a market cap-weighted index that skews very heavily toward Treasury securities because the U.S. government has been running large deficits for several years. So it has much greater exposure to Treasury bonds than the typical active manager.

There's a lot of other investors in the market that are skewing very heavily toward Treasuries that are not represented in the active manager bucket. Those are entities like banks that are looking for a safe place to park their capital and insurance companies that prefer the safety of Treasuries as well. So the typical active mutual fund manager is able to actually boost their returns by taking a bit more credit risk. So, even though they're charging higher fees, they can overcome that with the flexibility that they have to overweight certain areas of the market.

Benz: One thing I want to touch on that you did touch on in your piece because I think it's an important point. You point out that an investor's acumen in selecting managers is really important but that does require the investor to sort of honestly assess his or her abilities in that area. Do you have any thoughts on how investors can approach that question, like how should you think about how good a manager-picker you are?

Bryan: Sure. It's a great question and certainly, we think that it's possible to identify winning managers even in areas of the market like U.S. large-cap equities where the market looks a lot like what index funds are doing. One way you can determine your fortitude is how well have you stuck with managers in the past through their dry spells? Because every good manager will go through a period of underperformance, even the best. So it's important to be able to have the fortitude to stick with the manager through the rough patches.

But in terms of coming up with a framework to evaluate managers, you should really have a systematic philosophy. So, understand what you believe in, and stick to that and don't change course in the middle of your holding period. So, the way that we look at manager selection here at Morningstar, we focus on five pillars: performance, price, people, parent, and process. And I think of those price is the really good starting point because it's quantifiable.

The lower-cost manager that you invest with, the easier it is for them to overcome their fees and the greater likelihood that they have of outperforming. But process and all those other pillars are important as well. We try to make it easy for investors by assigning a medallist rating that conveys our conviction in whether or not a manager can outperform their category average over a full market cycle. So, it's important to understand your limitations and to know what your beliefs are ahead of time.

Benz: OK. Alex, valuable insights. Thank you so much for being with us to share them.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.