Actively Subtracting

William Ehart

A NEW RESEARCH report confirms that there are darn few reasons to consider an actively managed fund over an index fund—and, indeed, this year’s bear market has made the case for active funds even weaker.

Remember active fund managers, those stars of TV and magazines in days of yore? Purportedly, they could beat their relevant indexes by buying the best-performing stocks and bonds, shifting sector and country weights, and sidestepping market pitfalls. That notion seems almost quaint today—because it’s been proved so thoroughly and repeatedly wrong. Almost no one can consistently beat the market, except by luck.

That said, the semiannual Morningstar Active/Passive Barometer had highlighted a handful of fund categories—out of 20 that the Chicago research firm tracks—where more than half of the lowest-cost active funds had gone on to beat the average of index funds over various time periods. In some cases, three-quarters or more of the lowest-cost active funds—those with expense ratios in the bottom 20% of their category—had beaten the index funds over 10-year periods.

The data include funds that have folded or merged, so there’s no survivorship bias. Sound promising? Trouble is, like so much investment information, it’s based on historical market conditions that might not be repeated.

Therein lies the rub. When compared to its previous report with results through Dec. 31, 2021, Morningstar’s latest barometer—with data through June 30—shows noticeably lower 10-year success rates for those fund categories where active managers had earlier prevailed. One reason for the setback: Many active managers try to beat the indexes by taking on more risk, and that’s hurt during this year’s bear market.

In the accompanying chart, you’ll find the five categories with favorable success rates for the lowest-cost active funds over the 10 years ended Dec. 31, 2021, plus their 10-year success rates as of June 30.

You’ll notice the list doesn’t include any categories where active managers ply the U.S. stock market. They’ve been the least likely to succeed over both 10-year periods.

“The two keys for passive investing are the efficiency of the underlying markets and the cost of the fund,” Bryan Armour, Morningstar’s director of passive strategies research for North America, told me. “High-yield bonds and emerging markets work [for active managers] because there’s not as much clear information embedded in the prices of the underlying bonds or emerging market stocks.”

Yet, as the new data suggest, whatever enabled some actively managed funds to outperform in the past may not persist in the future. What looked like a lay-up six months ago for foreign small-mid blend funds and for diversified emerging markets funds now looks more like a toss-up. The active manager success rate in the high-yield bond category has also fallen sharply.

Also keep in mind that foreign small-mid blend funds and European stock funds are the categories with the smallest data sets. In each case, fewer than a dozen active funds existed 10 years ago. The upshot: Morningstar’s Armour said the sample size is too small to draw conclusions, especially when sliced into quintiles by expense ratio.

What about that much-touted ability to sidestep landmines? Most active managers certainly didn’t scamper to safety before Vladimir Putin blew up the Russian stock market with his Feb. 24 full-scale invasion of Ukraine. You didn’t need to predict the war to see Putin’s Russia as a poor place to invest, but no doubt some stock pickers were lured by rock-bottom valuations.

“It wasn’t like [most] active managers were able to navigate that,” Armour said. “Some active managers were actually way longer Russia than our category and the indexes, and they didn’t get out ahead.”

I’m not optimistic about the odds of active management consistently outperforming in emerging markets. But it is an area in which I refuse for now to adopt a strictly market-cap indexing approach. As I’ve written before, I want to limit my exposure to China. That’s why I own Freedom 100 Emerging Markets ETF, which doesn’t invest in autocratic countries.

As a rule, I avoid the risk of high-yield “junk” bonds. Were I to venture there, I might consider a low-cost actively managed fund. The Morningstar numbers suggest that’s an area where there’s at least some hope for active management.

William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.

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