Morningstar Chimes in on the Active vs. Passive Debate
When Morningstar, the company that is universally known for ranking funds with its star-rating system, publishes a study highlighting the failure of active management, investors would be wise to take notice. Here is what researchers Ben Johnson, CFA and Alex Bryan found in the April 2016 edition of “Morningstar’s Active/Passive Barometer”:
“Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons, and experienced high mortality rates (that is, many are merged or closed). In addition, the report finds that failure tended to be positively correlated with fees (that is, higher-cost funds were more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success). Fees matter. They are one of the only reliable predictors of success.”
Regarding fees, we couldn’t have said it better ourselves. However, investors must pay attention not only to the fees charged by their investments but also to the fees charged by their advisors. They matter exactly to the same degree.
One distinguishing characteristic of this study is that rather than comparing active funds to indexes, the benchmark used was the average passive fund performance for each category. A “success” for a fund was defined as surviving the entire period and delivering a higher return than the benchmark. For the ten years ending 12/31/2015, all eleven equity categories and the one bond category examined (intermediate-term bonds) had a success rate of under 50%. This is quite similar to the data we see from Dow Jones S&P Indices in their semi-annual SPIVA® Scorecard. Five of the nine US equity categories had success rates under 25%! Lastly, when we look at average fund performance over the last five and ten years (weighted by assets), passive beats active for all nine categories of US equities. With one exception (Large Value, which was essentially a tie), this statement holds true even for the funds in the lowest quartile of fees.
For Foreign Large Blend and Diversified Emerging Markets, the average 10-year return for active funds was higher than the average for passive funds. This result combined with the majority underperforming implies that while there were some active funds that did well, many (if not the majority) of investors were not invested in them.
To summarize, it is no wonder that the legendary Charles Ellis refers to active management as The Loser’s Game. As with the movie WarGames, the only winning move for investors is not to play. This, of course, means sticking with low-cost passively managed funds, and keeping a close eye on other costs such as trading, taxes, and advisory fees.