There's a new tool to see how actively managed funds compare to passive ones.

Morningstar, the financial research behemoth, has launched a new "barometer" of active funds' performance, net of fees, as measured against the collective performance of a composite of passively managed funds.

The Active/Passive Barometer report will appear every six months and compare the performance of the two fund types over the trailing six months, one-year, three-year, five-year and 10-year periods within their respective Morningstar categories.


The inaugural report, released this month, shows passive management beating active almost down the line, says Morningstar's director of ETF research, Ben Johnson.

The report's release "is timely in that the active-passive debate is sort of freshly stoked coming out of 2014, which was one of the worst years for active managers in terms of how they fared compared to their relative benchmarks," he says.

With the recurring report, Morningstar seeks to fill a gap, Johnson says, given that much of the research on the subject comes from academic sources that are relatively "unintelligible" to average investors or from industry players with "skin in the game."


"So we wanted to ground this debate in the real experience of investors…. We think our approach is differentiated in that our benchmark for success is the composite of all of the performances of all the passive funds in a given Morningstar category," he says, and "we measure success if an active manager manages to survive through the end of the period and produce performance that exceeds that of the passive composite."

Active fund managers often explain their value by comparing their performance to an index they have "cherry picked," Johnson says, which does not factor in the cost of the funds.

"All of the calculations that we've done are backing out fees because investors can't spend gross returns," he says.

Morningstar's research has demonstrated reliably that the higher the fees the lower the returns for investors, Johnson says.

The study carves up the field of active managers, looking at the lowest-cost funds first and cascading down to the most expensive funds, he says.


"The intention is to reframe the conversation in such a way to make it more useful," he says. "This is very practical in that it reflects investor reality."

For any number of reasons, many high-cost funds still exist whether due to investor ignorance, inertia or the tax consequences associated with liquidating them, Johnson says.

However, the market has caught on to their inefficiency.

"Over the past 10 years," Johnson says, "95% of net new flows into all U.S. funds have gone into the lowest [fee] funds."

Over time, Morningstar anticipates honing its research to include other factors such as whether or not managers invest alongside their clients, another generally reliable predictor of fund performance, according to Johnson.

Key findings from the first report include:

• Actively managed funds underperformed their passive counterparts across nearly all asset classes and Morningstar categories examined in the report, especially in the 10-year period. They also experienced higher mortality rates, where funds merged or closed. The U.S. mid-cap value category was the only one where actively managed funds had a 10-year success rate above 50%.

• Low-cost active funds were more likely to survive and outperform than higher-cost active funds over the long term. But low-cost active funds had lower average annualized returns compared with the average passive fund in nine of the 12 Morningstar categories examined in the report.

• Over the trailing three- and five-year periods, 72.9% and 69.7% of active intermediate-term bond funds, respectively, beat their average passive peer, which surpassed the performance of active U.S. equity funds. No U.S. equity category notched a success rate higher than 50%in the same time periods.

• Actively managed U.S. value funds had higher long-term success rates than U.S. blend and growth funds. Active large-cap value, mid-cap value and small-cap value funds had success rates of 38.2%, 54.4 percent and 48.4%, respectively, for the 10-year period.

• Low-cost active U.S. mid-cap value funds had the highest success rate, at 68.2% for the 10-year period, while high-cost, active mid-cap blend funds had the lowest success rate, at nearly 5%.

• Over the past 10 years, 40.2% of actively managed foreign large blend funds survived and beat the average passive fund, nearly double the success rate of active U.S. large-cap blend funds.


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