Active mutual funds underperform passive funds, again

Credit: Mutual Fund Advisors


For the vast majority of individuals investors, investing in one or a small number of mutual funds or exchange-traded funds makes more sense than directly owning a set of stocks or bonds. For one thing, investors often sleep better with mutual funds, rather than fretting whenever one of their stock or bond holdings is mentioned in a news report. Also, for many individuals, mutual fund holdings are less likely to run afoul of conflict-of-interest difficulties in their professional work.

In a previous Mathematical Investor blog, we presented data on actively managed versus passive fund performance over various time horizons, based on the February 2019 Morningstar Active-Passive Barometer report. These data showed, for instance, that only 12.6% of actively managed U.S. large value funds outperformed a comparable passive index fund over a 3-year horizon, and only 8.3% did so over a 10-year horizon. Other data from this report showed that actively managed funds with the highest fee structure uniformly underperformed those with a low fee.

Morningstar’s 2022 report

Recently (February 2022), Morningstar released its latest update. Below is a table with some of the data from this report. 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 34.1 37.0 21.9 14.8 13.4 27.1 9.8
U.S. large growth 31.9 31.5 31.8 8.2 5.5 18.0 3.4
U.S. mid value 28.8 53.2 37.1 10.7 9.1 28.6
U.S. mid growth 46.0 52.2 56.1 37.9 41.5 32.6
U.S. small value 37.1 41.4 36.2 20.2 17.9 20.0 5.0
U.S. small growth 47.4 65.8 55.1 44.0 12.9 48.8 48.8
World large blend 38.9 26.5 18.9 16.7 22.2 10.0
Europe stock 53.3 73.7 50.0 42.9 21.8 80.0 16.7
Intermediate core bond 69.2 47.0 43.2 37.8 8.8 54.8 20.6
Corporate bond 64.2 47.5 26.0 28.9 33.3 25.0

Needless to say, these results are pretty grim for actively managed equity funds — almost all entries of the table are less than 50%. Indeed, the only equity categories exceeding 50% success are U.S. mid value stocks (3-year), U.S. mid growth stocks (3-year and 5-year), U.S. small growth stocks (3-year and 5-year) and Europe stocks (1-year and 3-year). NONE of the categories outperformed their passive counterparts over a 10-year or 20-year time horizon.

One other notable fact from the above table is the surprising finding, consistent with the 2019 report, that the lowest-fee actively managed funds almost always achieved higher 10-year success rates than the highest-fee funds. Additional data can be seen in the February 2022 Morningstar report.

We should add that if anything, the above results are optimistic for the actively managed funds, because of the well-known survivorship bias phenomenon. Note that the funds listed as “successful” in the chart above are those that both survived and outperformed over the period in question. Presumably almost all of the funds that did not survive had below-par performance.

Does indexing threaten the market?

One question that often arises in this context is whether growing numbers of passive, index-linked funds pose a long-term threat to financial markets (see for example this Barron’s report). In 2017, BlackRock estimated that 17.5% of global equities are in index-linked instruments. In 2019, Institutional Investor reported that the amount in U.S. index-linked funds roughly matches the amount in managed funds.

Some observers are concerned that index investing may lead to market inefficiencies, since index funds typically 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 index funds might not be truly independent of the creation of the index, or that the index was designed using a statistically overfit computer search. For example, a 2015 study found that recently minted U.S. exchange-traded equity funds scored a 5% average annual excess (above-market) yield before launch, based on backtest analysis, but a 0% average annual excess yield after launch. See this SSRN report or this Significance article 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.

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 in the intervening years. 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). 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.


As we have seen above, the latest data confirm that actively managed mutual funds are struggling to match passive, index-linked equivalents. In other words, relatively few active managers are able to consistently beat the corresponding passive benchmarks over the long term. Thus we can expect more assets to move into index-linked instruments in the future.

But concerns that indexing is leading to serious market inefficiencies, or that indexing threatens the stability of markets, appear 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. Thus while the index situation is worth monitoring, it does not appear to pose major difficulties for the time being.

In any event, the data clearly show that most individual investors would do well to follow the advice of Vanguard Funds founder Jack Bogle, Berkshire Hathaway founder Warren Buffett and Dimensional Fund Advisors co-founder David Booth: invest in one or a handful of low-cost index funds, selected according to a sober analysis of appropriate risk and time frame, perhaps with the assistance of a qualified professional, and, most importantly, hold these investments for the long term.

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