Mutual fund report card: February 2019

Introduction

In a previous Mathematical Investor blog, we presented data on hedge fund performance, covering the 28-year period from 1990 through August 2018. We found that while the HFRI Fund Weighted Composite Index (HFRI FWI) has nearly identical long-term performance growth as the S&P 500 index, the past eight years or so have not been favorable to the hedge funds. Indeed, some of the leading hedge funds have suffered the largest losses.

Along this line, we noted that Warren Buffett recently won his ten-year bet with a hedge fund manager — an S&P 500 index fund bested a basket of hedge-funds-of-funds, with a 125.8% overall ten-year gain for the S&P 500 fund versus a 36.3% average overall gain for the basket of hedge-funds-of-funds.

Those results are for hedge funds. What are the results for the larger world of mutual funds?

Morningstar’s 2019 mutual fund report

Recently (February 2019), Morningstar released its latest barometer report of mutual funds, measuring active funds versus passive funds (index-based, in almost all cases). Below is a table with some of the data from this study. Here “success rate” is defined by Morningstar as the percentage of actively-managed funds that survive and beat the comparable equal-weighted average passive fund return over the given period:

Active fund success rates (%) 10-year 10-year
Category 1-year 3-year 5-year 10-year 20-year (lowest fee) (highest fee)
U.S. large value 30.1 12.6 13.5 8.3 8.4 16.0 5.3
U.S. large growth 48.9 29.7 21.0 8.3 14.4 3.1
U.S. mid value 22.0 12.5 7.5 9.4 7.7 0.0
U.S. mid growth 75.8 58.9 48.6 30.3 35.7 25.0
U.S. small value 15.9 16.8 23.6 33.3 38.5 34.6
U.S. small growth 52.1 51.4 35.1 24.3 20.4 24.4
World large stock 41.3 26.8 30.1 26.3 37.1 11.8
Europe stock 24.0 21.7 12.5 43.3 100.0 33.3
Intermediate term bond 38.1 66.9 51.3 55.6 24.6 70.2 47.4
Corporate bond 28.6 59.2 53.8 66.7 80.0 80.0

Needless to say, these results are pretty grim for the actively managed equity mutual fund world in particular — almost all entries of the table are less than 50%. Indeed, the only equity categories with 50% or higher success are U.S. mid growth stocks (1-year and 3-year), and U.S. small growth stocks (1-year and 3-year). The picture is somewhat better in the bond listings — in the Intermediate term bond category there are three entries (3-year, 5-year and 10-year) with 50% or greater success rates, and these same columns are also higher than 50% in the Corporate bond category. Additional data (with essentially the same conclusion) can be seen in the Morningstar report.

The other notable fact from the above table is the surprising finding that the lowest-fee actively managed funds uniformly had higher 10-year success rates than the highest-fee funds (except in the Corporate bond category, where the two entries are equal). In the full Morningstar table, this is true in all categories listed (except, again, in the Corporate bond category, where the two entries are equal).

Other results from the Morningstar report

Here are a few other highlights from the Morningstar report (paraphrased):

  1. In 2018, only 38% of actively managed U.S. stock funds survived and outperformed their passive benchmark, which is down from 46% in 2017.
  2. Actively managed fund success rates fell from 2017 to 2018 in 16 of the 20 categories examined. The declines were greatest among active foreign stock funds.
  3. Success rates tend to be even lower over longer time horizons. Only 24% of all actively managed funds beat their passive benchmarks over a 10-year horizon. Long-term success rates tended to be higher among non-U.S. stock funds and bond funds, and lower among U.S. large-cap funds.
  4. As noted above, the lowest-fee actively managed funds had success rates on average about twice as high as the highest-fee funds (32.5% success rate versus 17.2% success rate). As the Morningstar report notes, this reflects not only the cost advantages of low-fee funds, but also differences in survival rates, since roughly 67% of the lowest-fee funds survived, whereas only roughly 50% of the highest-fee funds survived.
  5. The large-growth category has been particularly challenging for active fund managers. More than 60% of the actively managed funds that existed in the large-growth category 15 years ago have closed, and only 10.7% managed to both survive and outperform their benchmark.
  6. In most large equity categories, investors who did select actively managed funds are evidently favoring successful, lower-fee funds, as evidenced by the fact that the average asset-weighted return exceeds the average equal-weighted return in most time horizons.

Does indexing threaten the market?

Some writers have warned that the growth of passive, index-linked investing poses a long-term threat to the market. We wrote about these concerns in an earlier Mathematical Investor blog. Some are concerned that index investing may lead to market inefficiencies, since index funds purchase securities without consideration of underlying strengths and weaknesses. Others are concerned that index investing may emphasize certain firms and sectors at the expense of others. There is also concern about a self-fulfilling prophecy effect — the relatively good performance of the leading index funds in recent years might be attracting investors to these funds who may dump them in a downturn. Finally, there is a very real concern that many of the newly minted exchange-traded funds might not be truly independent of the creation of the index. See this Mathematical Investor blog for further details.

Some of these concerns were addressed in a 2001 study. The authors studied the problem from several different angles. They concluded:

[T]he flow of funds into the S&P 500 has no identifiable effect on the excess return of the S&P 500 over actively managed mutual funds. This analysis suggests that the success of indexing has not been a self-fulfilling prophecy. … Our results [also] indicate that presence in the S&P 500 definitely does not increase the price of a stock; in fact, inasmuch as it has any effect, it tends to reduce a stock‚Äôs price-earnings multiple. … Overall, the evidence is that indexing has not inflated the prices of stocks in the S&P 500.

That study was published in 2001, and index-based investing has increased significantly since then from 9.9% to 24.9% of the U.S. market.

In February 2018, Brad Steiman of Dimensional Fund Advisors Canada published an analysis that updated and extended some of the results of the earlier study, analyzing whether indexing has led to a less efficient market. If this is true, then active managers should, on average, achieve increasingly better results, by exploiting inefficiencies that are indirect results of indexing. To that end, he analyzed the average performance of actively managed U.S. funds from 2004 through 2016, relative to their Morningstar category benchmark. He found that this ratio has been remarkably stable during this period, mostly varying between 30% (in 2012) and 39% (in 2013); the only exception was in 2016, when the ratio was 25%. Needless to say, these data do not support the increasing inefficiency hypothesis.

Steiman also analyzed the extent to which S&P 500 stocks move in lockstep. He exhibited a histogram of the range of S&P 500 index component returns in 2017. These data varied very widely, ranging from +133.7% to -84.0%. Amazon was typical of the above-average gainers, with a 56.0% gain; General Electric was typical of the losers, with a 42.9% decline. Again, such a wide variation in performance refutes the claim that indexing has led to inefficient lockstep behavior of the S&P 500 component stocks.

Conclusion

The latest data confirm what many have sensed for years, namely that many actively managed mutual funds are struggling to match passive, index-linked equivalents — indeed, as can be seen in the data above, relatively few active managers are able to consistently beat passive benchmarks. Thus we can expect more assets to move into index-linked instruments in the future. Indeed, according to this Bloomberg report, assets in passively managed large-cap funds last year exceeded those in actively managed large-cap funds.

But concerns that indexing is leading to serious market inefficients, or that indexing threatens the stability of markets, seem to be overblown. To the contrary, there is reason to believe that greater levels of indexing may provide increased opportunities for active managers, say in exploiting fundamental weaknesses inherent in index investing.

Either way, this situation is worth monitoring. In the investment world, no law or principle remains in effect forever.

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