Active funds: frequent underperformance, higher expenses and underrated risks

The scale of passive funds is growing. Passive funds now account for 32.5% of US assets managed in mutual and exchange traded funds. According to data from Morningstar, $223.1 billion outflowed from actively managed funds; meanwhile, passive funds saw inflows of $418.6 billion in 2015.

For the year 2015, 66.1% of large-cap managers, 56.8% of mid-cap funds and 72.2% of small-cap managers underperformed their relevant S&P US benchmarks. Over long time periods, 82.1% of large-cap funds and 88.4 % of small-cap managers fail to match their benchmarks. Of all the 678 domestic equity funds in the top quartile for performance over the year to September 2013, only 4.3% stayed in the top quartile by the end of September 2015. This means very low persistency.
There are two ways to earn higher returns: to find an excellent manager or an unbeaten strategy or to reduce the cost. It is proven that the former is easier said than done. On average, active funds will roughly match the index before fees; that means that after fees, most of them will lose to the index. Style Research’s survey provided evidence for it. Among 425 global equity funds, 31% of them outperformed the MSCI World. Without taking any costs into account, however, 59% of representative samples beat the index. That is to say, 28% of funds charged too much to maintain the beat-the index performance.
For those that do manage to outperform, size can become a problem. Strong performance attracts more money and larger funds find it much harder to beat the market. A research by Stambaugh found that the scale also affects performance and that a more skilled large fund can underperform a less skilled small fund.

Research also showed that funds with a higher active share (deviation from the index) have a better chance of outperformance. But this does not lead to better risk adjusted returns. Morningstar found strong evidence of increasing risk as active share rose. The higher active shares a fund have, the higher volatility (standard deviation), the much larger drawdowns. In another word, high-yield funds can have beautiful return, while investor would lose a lot more than index funds once they do not perform well.

This means that investors should focus on reducing expenses, and invest in passive funds with low turnover.