As we close out 2014, the question of how well actively managed funds fared against their passively managed counterparts hovers in the background of much of the news about fund returns and portfolio management. Over the years, both camps have offered sound reasoning for focusing on one investment practice instead of the other. But they may perhaps both be right.
From the passive camp, we hear that it is nearly impossible for a fund to continually outpace its benchmark index, and the effort isnt worthwhile. Not only do active fund managers have to pick the right blend of stocks or bonds, they must also compete against an index that is non-investable and doesnt suffer from the drags of expenses or cash allocation. [Virtually all mutual funds must keep some cash on hand to meet potential redemptions, which in up markets can cause a fund to underperform its benchmark.] Lippers 2014 Quick Guide to Open-End Fund Expenses indicates the average actively managed front-end load/no-load fund must beat an average annual expense ratio of 1.10% just to break even.
By contrast, actively managed fund proponents state that passively managed funds have no chance of beating the index or providing alpha, but will always lag their benchmarks by the amount of expenses and cash drag. According to Lippers Quick Guide, the average passively managed front-end load/no-load fund suffers an expense drag of 0.83%. Obviously, that drag can vary considerably, from the cheapest no-load passively managed fixed income fund [0.08% for Vanguard Total Bond Market Index Fund Admiral Shares,based on the most recently reported prospectuss net expense ratio] to the most expensive passively managed no-load equity fund [3.37% for AMIDEX35 Israel Mutual Fund No-Load].
A LESSON FROM THE REAL WORLD
According to market folklore, actively managed funds can underweight poor performers and overweight outperformers in most market conditions, while their passively managed counterparts must maintain their benchmark weightings, thus putting them at a competitive disadvantage. Unfortunately for actively managed funds, the real world is not quite that flexible.
Fund investors, after seeing their net worth plummet during the 2008 financial crisis, began to turn their attention and wallets to passively managed funds. At the end of 2008, actively managed equity funds accounted for 76%, or $3.4 trillion, of the $4.5 trillion of total net assets [TNA] under management for the equity mutual fund universe [including conventional funds and ETFs], while their passively managed counterparts accounted for 24%, or $1.1 trillion of the sum. By Oct. 31, 2014, the TNA of passively managed equity funds jumped to $3.6 trillion, 32% of the $11.2 trillion ascribed to equity funds, while the TNA of actively managed equity funds climbed to $7.6 trillion, accounting for 68% of the sum. The TNA of a fund consists of two primary components: net money flows and underlying security performance of the portfolio.
Since the beginning of 2009, investors have pumped some $1.042 trillion into passively managed equity funds and just $363 billion into actively managed equity funds. Meanwhile, they have seemingly embraced actively managed fixed income funds over passively managed fixed income funds, injecting $914 billion versus $371 billion over the five-and-three-quarter-plus years. Active fixed income managers such as DoubleLines Jeffrey Gundlach and PIMCOs recently departed fixed income guru Bill Gross have spurred on believers to the benefits of active management [especially in less liquid or scarcely followed securities].
So, how have passively managed funds done against actively managed funds thus far in 2014? After removing the outsized returns of bear-oriented or leverage-focused short-bias funds, leveraged equity funds and leveraged fixed income funds, year to date through Oct. 31 passively managed equity funds have returned 4.32% on average, underperforming their actively managed cousins, which returned 4.39%, by about 7 basis points [bps], whereas actively managed fixed income funds, returning 4.82% year to date, have outpaced their passively managed cohorts, returning 4.64%, by 18 bps. That pattern holds at the one-, three- and five-year marks, where actively managed equity funds have posted stronger returns than their passively managed brethren by 59, 127 and 36 bps, respectively.
As we can see in the table above, actively managed fixed income funds outshone their passively managed counterparts in all periods except the 10-year, when passively managed funds outpaced their active brethren by just 10 bps. These very broad-based comparisons, however, are not that instructive. A better measure is to look at how well the funds beat their stated benchmarks their relative returns. Excluding the short-biased and leveraged funds again, actively managed funds had a much stronger track record of beating their stated benchmark than did passively managed funds. But there was only one year, 2009, when actively managed funds beat their benchmark by more than 50% [57%]. Interestingly, in 2008 the number of passive funds beating their benchmark [40%] was greater than the number of actively managed funds beating their benchmark [37%].
There are two more takeaways. First, when actively managed funds beat their stated benchmark, they did so with much more magnitude than did their passive counterparts. However, as might be expected, when actively managed funds underperformed their stated benchmark, their losses were also greater than their passive brethrens. There is obviously greater volatility/risk in the actively managed group.
Second, we note that higher-than-expected win rates were seen in the passively managed funds relative returns. We hypothesize three causes: The first is that many of the passively managed funds use price-only return indices for their benchmark, while we use total return [which includes reinvested dividends] in our relative return calculation for the funds. The second possible cause is cash drag. As stated earlier, the maintenance of a supply of cash for possible redemptions is a drag on performance in up markets it is a relatively underperforming asset [especially with todays short-term rates]. However, in a declining market the presence of cash can help mitigate portfolio losses.
The final possible cause is the inclusion of "index-based funds" into the passive group rather than using just pure index funds. An index-based fund uses indices as its primary filter for the purchase and sale of securities, but it generally does not hold every security of the index. However, these funds often maintain the same index sector weightings.
PADDING THE COFFERS
Over the last fiveand-three-quarter-plus years, investors have padded the coffers of bond funds and mixed-asset funds [target date and target risk funds], more than likely as a response to the 2008 financial crisis and because they needed to diversify their portfolios a little more. In the last years of the 1990s and the early part of the 2000s, investors had been encouraged to use domestic large-cap funds as their primary holdings for their core and satellite asset allocation process.
Therefore, its not surprising that in 2004 the largest asset allocation to open-end funds, other than money market funds [20.4%], was to large-cap funds [17.5%]. After the meltdown, as investors began reallocating their portfolios, the obvious conclusion was to redeem from their largest holdings [which had performed horribly in 2008; the average large-cap fund declined 38.51%]. Actively managed large-cap funds witnessed the second largest net redemptions of all the macro-classifications, handing back some $295.8 billion, significantly less than money market funds net outflows [-$956.6 billion].
Money market funds had built up their total net assets to just over 25% of the open-end universe in 2009. Despite the mass redemptions experienced by actively managed large-cap funds, the group still sported the third largest amount of TNA under management of all the macro-groups, with $1.703 trillion just behind money market funds $2.255 trillion and actively managed mixed-asset funds $1.712 trillion. It would appear that the recently reported death of actively managed large-cap funds was grossly exaggerated!
What are clients to do, concerning the ongoing debate of passive versus active? In a 2009 report, Thomson Reuters chief index strategist Andrew Clark highlighted that over the preceding 20 years, active investors added incremental returns to their portfolios by using a combination of actively and passively managed funds. He showed there were times when risk-adjusted returns of passively managed funds clearly outperformed active funds [most significantly between 1994 and 1999], whereas actively managed large-cap funds outperformed passively managed funds from 1990 to 1994 and from 2000 to 2002. Clark concludes, "Since there are periods when one type of fund outperforms the other, allocating a portfolio between actively managed and passively managed funds has been shown to provide additional returns to investors willing to accept additional transaction fees and possible larger drawdowns." However, he also suggests that the purely do-it-yourself long-term buy-and-hold investor might be better served by focusing on passively managed funds.
The debate will continue between actively managed and passively managed fund proponents. But the bottom line for clients and advisors alike is their need to maximize returns while minimizing risk. Perhaps by allocating and periodically rebalancing our limited resources to both passively and actively managed products, we will be able to reap the benefits of both worlds over the long haul.
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