US Equities: Does Active or Passive Investing Pay?

Morningstar's chart looks at one-, five-, and 10-year periods for U.S. equity funds. In the long run, active funds underperform their passive counterparts due to higher fees

Tim Strauts 3 February, 2016 | 3:41PM


Tim Strauts: In today's chart, we are going to examine Morningstar's Active/Passive Barometer. It is unique in the pragmatic way it measures active-manager success. For instance, it compares active managers' returns against a composite made up of relevant passive index funds. We believe this is a superior approach because it reflects the actual net-of-fee performance of passive funds rather than an index, which isn't investable.

What's more, the Active/Passive Barometer assesses active funds based on their beginning-of-period category classification so as to replicate the opportunity set an investor could have chosen from at the time. It does not purport to settle the active-passive debate. Rather, it aims to ground that debate with data that reflect investors' shared experience and to assess investors' odds of succeeding with active managers across asset classes, time periods, and fee levels.

The chart looks at one-, five-, and 10-year periods for U.S. equity funds. In each box, there are two numbers. The top number is the success rate, which is the percentage of active funds that outperformed the passive benchmark. The bottom number is the return of the passive benchmark over the period.

In the long run, active funds underperform their passive counterparts due to higher fees and trading costs. You'll notice that only two style boxes had a success rate of more than 50% for any period. In general, the one-year success rate is more volatile than the 10-year success rate. Over any short-term period, active managers will have a wide range of returns, which can lead to strong outperformance or underperformance versus the passive benchmark. Also, there is a correlation between success rate and performance of the category.

Over the last year, the small-value style box has had the worst performance, but it has the highest success rate. This is because most active managers don't only hold small-value stocks in their portfolio; they likely has some mid-value and small core stocks, which helps the active manager outperform when small value has a bad year.

In conclusion, this analysis shows that, on average, active managers underperform. This doesn't mean that active management doesn't have a place in a portfolio but that an investor needs to look to other factors such as management fees, stewardship, and investment process to find the best active funds, which is what the Morningstar Analyst Rating seeks to capture.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Tim Strauts