It has been a dire and highly volatile stock market year so far. The opportunity for active investors to make a difference and outsmart the market. Fine words notwithstanding, more than three quarters of active managers have failed again this year. “The biggest cause of active funds’ failure is their inability to survive.”
This is according to the latest Morningstar European Active/Passive Barometer, a semi-annual report that compares the performance of European-based active funds with passive funds in their respective Morningstar categories.
According to senior analyst Dimitar Boyadzhiev and associate director Jose Garcia-Zarate, 2022 in particular saw a typical environment in which active managers should be expected to win more easily over passive alternatives, «because these (passive alternatives) usually undergo the full downward market valuations,» they wrote.
Yet again, the success rate of active managers in Europe made no impression, or at best, a bad one. “The publication clearly leaves nothing to be desired. Most actively managed funds do not beat their (relevant) benchmark and de facto have no existence. A harsh but indisputable conclusion,” argued Jeffrey Schumacher, chief research manager at Morningstar.
Passive better than active
According to Morningstar data, an average of 35 per cent of active equity funds managed to survive, outperforming their passive alternative over a one-year period to the end of June 2022.
Only seven share classes had a success rate of more than 50 per cent for active managers during this period. Boyadzhiev and Garcia-Zarate concluded that high costs and poor investment choices are systematically killing active funds.
Over the 10 years to June 2022, the success rate for active managers was less than 25 per cent in more than half of the 72 asset classes studied. In only three categories; global dividend stocks, UK dividend stocks and Swiss real estate, more than half were able to both survive and outperform their average passive competitors over the 10 years to June 2022.
“The biggest cause of the failure of active funds is their inability to survive,” Boyadzhiev and Garcia-Zarate argued. “This is often the result of poor performance that can be explained by a combination of wrong investment choices and the compound negative effects of higher fees relative to their low-cost passive competitors,” the men wrote.
“Our analysis shows that the 10-year survival rate for active funds in the aggregate group of share classes from 2014 to date averaged 46 per cent,” the researchers wrote. The average 10-year survival rate for passive funds was 60 per cent over the same period.
Fixed income also disappoints
In just seven of the 23 fixed-income categories surveyed by Morningstar, more than half of the managers managed to outperform the passive alternative in the 12 months to the end of June 2022. Although the percentage of active outperformers among fixed-income managers is higher than for equities at 40 per cent, longer-term results are disappointing in this category as well.
Looking at the average success rate for active fixed-income managers over the past 10 years, Boyadzhiev and Garcia-Zarate concluded that only one in five managers managed to outperform. For active equity managers, that figure is 24 per cent.
“Among the ‘bright spots’ we find success rates for active funds in the euro corporate bond and euro high-yield bond categories: 43.3 per cent and 39.7 per cent respectively,” the barometer said.
Active is a ‘Must’
One category that is mostly seen as the as-yet uncultivated haven for the active investor is emerging market equities. Many emerging market investors claim that this category can only be actively invested in, but that does not rhyme with the data.
Only one in four active EM equity funds manages to beat passive alternatives on a 10-year average. On average, passive EM equity funds registered in Europe outperform the active alternative in three quarters of cases after one year. After 20 years, passive does better in 81.3 per cent of cases, according to the barometer.
The dismal percentage of active managers that both survived and outperformed in global large-cap blend and Europe large-cap blend was 5.3 per cent and 11.2 per cent, respectively. The success rate in the US large-cap blend category also remained particularly low at 6.9 per cent, Morningstar data showed.
Costs and returns negatively correlated
According to Schumacher, the costs charged are disproportionate to the alpha potential a strategy can offer. Previous studies by Morningstar have shown that there is a negative correlation between cost levels and returns: cheaper funds have more Morningstar stars on average.
According to Schumacher, it should be added that investors are not always only concerned about returns, but other aspects can also be important, such as sustainability considerations or the level of income generation.
“In that respect, I think there is definitely a future for active funds, but fund houses will have to critically monitor their fund offerings and focus on proven expertise, share economies of scale with investors and align costs with alpha potential in order to be more likely to beat the index.”
The Barometer
Morningstar’s Active/Passive Barometer evaluates active funds against a composite of existing passive funds, rather than against a no-cost index. In this way, the benchmark reflects the actual performance, after fees, of the passive funds available to investors. The performance of different currency units is also taken into account in the Barometer.
The Barometer compares nearly 30,000 European-based active and passive funds, representing more than €7000 billion in assets, almost 75 per cent of the total European fund market.