Stock Groups

In one of the most volatile markets in decades, active fund managers underperformed again


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

It is possible that 2020, the first half of 2021, and any year thereafter, should have seen active management outperform passive, index strategies.

Active managers claim that boring markets are not conducive to their ability to perform well. This has been true for decades. Active managers can outperform passive counterparts when things are changing quickly.

They did have a shot during the volatile market of 2020-2021.

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

Morningstar found that only 47% of the approximately 3,000 active funds were able to survive and performed better than their passive counterparts in the twelve months from June 2021.

“Roughly half of the beat was lagged. “It was exactly what you’d expect from a coin-flip,” stated Ben Johnson, global ETF research director and author of Morningstar.

Morningstar Active/Passive is an semi-annual report which compares the performance of U.S. funds with passive counterparts. When evaluating fund returns, it considers two factors: survivorship bias and the cost of fees.

It is crucial to consider survivorship bias. In a 10 year period, approximately 40% of large-cap funds go bust. Many fund managers make poor stock picking decisions, which leads to funds being closed.

Johnson said to me that all funds are included, even those that failed to survive. Johnson said that there was money in these 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

If you take a longer look at the performance of active manager, things get much worse: Only 25% of active funds have outperformed passive funds over a 10-year span, according to Morningstar.

Even worse is the situation for large-cap equity fund managers, as these are most investors’ assets: Over a period of 10 years, only 11% active large-cap funds have outperformed passive funds.

This is the conclusion: While fund managers might have a “hot hand” for 1, 2, or 3 years, it seldom lasts. Even those who have “hot hands”, even for a short time, often fail over longer periods.

Johnson concludes: “There is little to no merit in the idea that active funds can navigate market volatility better than passive funds.”

Stock pickers could be wrong in so many ways.

Stock pickers are not the best at picking stocks, as has been proven since the 1930s. However, until the 1960s, there was no reliable, comprehensive data on stock prices.

Most active traders were found to be in the red when investigators started looking through evidence.

This evidence was stronger in the 1970s, 1980s, when Charles Ellis’ book “Winning the Loser’s Game” and Burton Malkiel’s book “A Random Walk Down Wall Street”, both chronicled the poor performance of active fund managers.

Malkiel stated in an iconic passage from “A Random Walk Down Wall Street”, “A blindfolded monkey can throw darts at the financial pages of a newspaper” that “a blindfolded monkey selecting a portfolio would be just as successful as one selected carefully by experts.”

Why aren’t active managers able to outperform?

This is a multifaceted problem. The first was active trading, which involved market timing. It is evident that it is difficult for market timing to be achieved.

Larry Swedroe from Buckingham Strategic Wealth told me that it is difficult to predict the market.

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, the performance of active fund managers is declining because they are mostly competing against professional investors. Swedroe explained that “the pool of victims is shrinking dramatically.” Swedroe said that most stock were held by individual owners before World War II. Only a very small amount of trading today is conducted by individuals. It’s difficult to challenge institutions for the vast majority of trading.

Managers of active bond funds did better

Although stock-pickers’ results were disappointing, the long-term success rates of foreign-stock, real-estate, and bond funds were higher.

Why is it that active stock pickers are better at these areas?

Johnson explained that these are markets where there is less competition and therefore, fewer participants.

In the past year, active funds within the intermediate core bonds category have outperformed passive counterparts by nearly 85%. Johnson stated that active funds within the intermediate core bond category have seen a rebound in credit markets post-COVID crisis. They are more inclined to take credit risk than their index peers.

However, active bond managers begin to lose their edge over time: After 10 years, 27% outperformed passive Indexes.

Low-cost managers are better than high-cost ones

Morningstar’s report reveals that it is better to select the least expensive active manager if you want to make a decision.

Over the period of 10 years, the cheapest funds were twice as successful as those with the highest success rates (35% success rate against 17%). Higher survival rates were also recorded for the cheaper funds: 66% of funds that survived, while only 59% of most costly funds did.

We find that actively managed funds are cheaper than those with higher costs.

Swedroe explained to me that an active manager with a good track record that does not charge the same fees as a passive fund might be worth considering. But it is extremely difficult to find such a manager.