Stockpickers are finally earning their fees once again.
After more than a decade of chronic underperformance, actively managed stock mutual funds and exchange-traded funds have been beating their passive peers at a steadily rising rate during the stock market’s selloff this year.
Just over half of U.S. stock funds outperformed the average passive portfolio for the year through May, compared with 45% in 2021. While that figure might not quite sound boast-worthy, the average is dragged down by ongoing struggles among active growth fund managers—less than 30% of whom have managed to beat their passive counterparts’ average returns, according to Refinitiv Lipper.
The bright spots have been in the value and core stock segments, where a significant majority of active portfolios have been outperforming across small-, mid-, and large-capitalization stocks. Eighty percent of active large-cap value funds—and 62% of active mid-cap core funds—beat the average return for comparable passive funds through May, according to Refinitiv Lipper. Those rates are more than double their three-year averages.
Of course, in a very bad market, almost all stock funds are down for the year, but active funds in many stock categories have significantly stemmed losses. For example, the average annual return through May for active large-cap value funds was minus 4% compared with minus 7.3% for comparable passive funds, and active small-cap core funds returned minus 10.9% compared with minus 13.1% for passive peers, according to Refinitiv Lipper.
“While there are tons of ways to cut and slice the data—versus stated benchmarks, the S&P 500 indexSPX –0.08% , or passive funds—no matter how you look at it, it’s rare to see active equity managers outperforming six out of nine Morningstar style categories versus their long-term averages,” says Scott Krauthamer, chief operating officer of AllianceBernstein ’s global business development organization.
If there were ever a time for active managers to demonstrate their value, this year has been it. As the bull market came to a tumultuous end early in 2022, major dislocations in pricing between sectors and individual stocks created an optimal environment for savvy stockpickers to suss out winners from losers.
“Active shines when you have changing market leadership,” says Antonio Picca, manager of the Vanguard U.S. Momentum FactorVFMO +0.03% ETF (ticker: VFMO), a top-decile performer among mid-cap growth funds with a minus 19.8% return compared with a minus 28.5% category average through July 5. “We’ve been able to navigate the transition between Covid stay-at-home tech-heavy trends to reopening cyclical trends, and more recently to an outperformance of energy and defensive.”
Nevertheless, it’s too soon for managers to wash down years of humble pie with Champagne, analysts say.
Since the number of low-cost passive funds exploded in the 1990s and beyond, challenging traditional active managers to prove themselves worthy of their higher fees, reams of research have pointed to the same conclusion: Over long periods, active managers have a hard time sustaining outperformance. They either die off or are unable to keep up outperformance through different market cycles.
“The fact that managers would do a bit better in conditions that are absolutely awful doesn’t really matter much over the long-term horizon,” says Ben Johnson, director of global ETF research at Morningstar.
Johnson found that over a 10-year period through 2021, just 8.2% of active large-cap growth funds and 14.2% of active large-cap value funds have survived and beaten their passive counterparts. The best long-term outperformance among all active U.S. stock funds is by small-cap growth portfolios, with 44% of funds beating passive funds.
Nevertheless, this year’s best performers have been posting some impressive numbers. The small-cap blend portfolio Boston Trust Walden Small Cap (BOSOX) posted a minus 14.98% after fees through June, compared with minus 22.09% for its benchmark index, Morningstar U.S. Small Cap Extended. Among the top five mid-cap value performers in that period is Nuance Mid Cap ValueNMAVX –0.54% (NMAVX), with a minus 7.02% return versus minus 12.08% for its benchmark, Morningstar U.S. Mid Cap Broad Value. The top performer in the large blend group, Virtus KAR Equity IncomePDIAX –0.20% (PDIAX), posted a minus 4.31% return compared with minus 21.25% for its Morningstar U.S. Large-Mid index.
A New Era
Proponents of active management posit that this could be a new era for stronger active portfolio performance. The past dozen years of steadily rising stock indexes have been enormously challenging for stockpickers, with the bull market being led by a handful of tech names. Any manager who, in an effort to differentiate a portfolio or to try to beat the market, didn’t own Amazon.com (AMZN), Facebook parent Meta Platforms META –0.76% (META), Apple (AAPL), and Google parent Alphabet (GOOGL) was almost sure to lag behind the market.
Active managers tend to have more of a value and quality bias, “so a year like this is a tailwind for them,” says Scott Opsal, director of research and equities at the Leuthold Group. “Unprofitable stocks are down 60%, and profitable stocks are down 18%. If you’re an active manager who doesn’t like money-losing companies, that’s a big plus right now.”
The environment could get better for active managers if interest rates continue to rise and the cost of capital goes up, further exposing weaker companies, says Brian Katz, lead investment strategist at the Katz Group, an advisory in Melville, N.Y. “When capital is cheap, it allows companies that should not be in existence anymore to continue to exist. When that cost rises, they fail.”
Meanwhile, stock-price gyrations are creating opportunities for managers to find the kind of market mispricing they have only dreamed of in recent years.
“I’ve never seen such a wide disparity between consumer discretionary and energy,” says Krauthamer, adding that those sectors’ performance usually varies by a few percentage points, but through May this year, there was an 88-point difference. “Consumer discretionary was down 12%, and energy was up 76%. This doesn’t mean short energy and go long consumer—it says when the disparity is so wide, maybe there are some dislocations that don’t make a whole lot of sense.”
The jury is out on whether active managers will meet the moment to their full potential. Active large-cap funds have so far been slow to react to changing times.
“Despite an inflection in Fed policy, inflation, political control, peacetime to wartime, and a host of other major shifts, active funds have largely maintained directional biases versus 2019,” notes Savita Subramanian, head of U.S. equity and quantitative strategy at BofA Securities, in a June report.
She found that the turnover rate for active large-cap funds over the past 12 months was lower than in the much steadier environment of 2019, and portfolios continue to have an entrenched growth and technology bias.
Many managers with success so far this year were willing to pivot and ease up on traditional growth names in favor of defensive and cyclical sectors such as consumer staples, healthcare, energy, and financials. These funds typically have high “active share,” which is a measure of how much a portfolio’s holdings differ from a benchmark.
“We are adaptable and pragmatic with where opportunity is, rather than being dogmatic about buying growth at any price,” says Rajiv Jain, manager of GQG Partners US Select Quality Equity (GQEIX), which was the top-performing large growth fund this year through June 17, with a minus 5.29% return, versus minus 30.86% for its category.
The fund’s current exposure might seem to peg Jain as a value investor, with deep underweights in technology, communication services, and consumer cyclicals, and big allocations to energy and utilities. But he argues that his portfolio continues to have a growth strategy.
“We define growth as where the growth is going to be. Is Netflix [NFLX] really a growth business right now? Our view is energy is one of the new growth areas. And you’ll be better off owning utilities than companies like PayPal Holdings [PYPL],” he says.
But active share isn’t a reliable indicator of outperformance. Most of the top-performing large-cap growth mutual funds have active-share scores of more than 70%—but so do the bottom-performing portfolios in the category.
GQG Partners US Select Quality Equity has an active share of 87.3%, but Baillie Gifford US Discovery (BGUIX) has a 98.9% active share and is one of the category’s worst performers, down 39.9%.
“A high active share doesn’t say you are a good manager; it says you are a high-conviction manager,” Krauthamer says. “You can have high conviction and be wrong. You have to couple active share with the persistency of alpha and look at whether a manager’s ability to provide alpha is a repeatable fundamental process.”
By far the biggest indicator of a fund’s chance for long-term outperformance is fees. The higher the fee, the more value a manager has to add to offset them. That’s a tall order most don’t deliver on. Low-cost active funds beat passive funds at a significantly higher rate.
Consider the percentage of actively managed large-cap blend funds whose performance outpaced average passive returns over the 10 years through 2021: just 9.5%, according to Morningstar.
While that’s a dismal record, the rate is worse—1.3%—when considering only the highest-cost funds. It improves to 19.2% for the lowest-cost group.
Active stock mutual fund fees have been coming down steadily—from about 0.93% to 0.64% on an asset-weighted basis since the beginning of the bull market in 2009, compared with the current average 0.09% for index mutual funds, 0.16% for passive ETFs, and 0.46% for actively managed ETFs, according to Morningstar Direct.
But active mutual funds haven’t been able to stem a yearslong trend of outflows, as investors have sought cheaper and higher-performing options.
Passive Aggressive
Assets in passive U.S. stock mutual funds exceeded assets in actively managed counterparts in August 2019 for the first time and have continued to firm up their dominance since then. Through this year’s first quarter, a net $128.1 billion drained out of actively managed funds excluding money-market funds, while passive funds took in a net $199.4 billion, according to Lipper.
The biggest outflows were from active large-cap growth funds—$28.9 billion—while passive large-cap growth funds took in a net $7.4 billion, according to Lipper.
Increasingly, investors are turning toward the growing universe of ETFs for active management. These funds represent less than 15% of the overall $10 trillion ETF market, but their low costs and simplicity have appeal, and they have continued to plump up with fresh assets this year. Even in the large-cap growth category, active ETFs had net inflows of $131.4 billion through May, according to Lipper.
When it comes to portfolio construction, many advisors say the passive-versus-active debate is too simplistic. A “for or against” argument misses the important point—which is that each can have a vital role in a portfolio, Katz says.
He uses passive strategies in the U.S. large-cap segment and active strategies where they have a better record of proving their fees are worthwhile. “We try to find those segments of the equity markets that are least efficient and allocate to active managers there, and, in segments that are more efficient, we keep costs down by allocating to passive managers,” Katz says.
Small-cap and emerging market stock managers have higher outperformance rates than U.S. large- and mid-cap managers because there are more undiscovered companies in those markets that savvy stockpickers can bet on.
Over the three years through 2021, some 65.8% of active U.S. small-cap growth funds beat their passive peers, as did 73.7% of European stock funds and 61.3% of diversified emerging market funds, according to Morningstar.
Investors who want to add a tilt to their broad U.S. stock fund exposure can do so through more-concentrated active portfolios, Katz says.
Picking Active Funds
When going with active funds, do so with eyes wide open: Many active portfolios will have a significantly wider dispersion of returns than comparable passive funds. According to Bank of America, 56% of U.S. active large-cap stock managers outpaced the Russell 1000 in this year’s second quarter. But while active large-cap funds have been some of the best performers, they’ve been the worst, too. Their returns for the year through July 6 ranged from 4% to minus 62%.
The recent poster child for risks associated with concentrated active portfolios is the ARK Innovation ETF (ARKK), which caught investors’ fancy—and $1 billion of their assets—in 2020 when its big bets on a handful of tech stocks put it in at the very top of its category, with a 152.8% return compared with its benchmark index’s 34.9%. A year later, it hit the very bottom, with a 23.4% loss compared with the benchmark’s 18.8% gain.
“If you’re paying for active, you should have something that performs different than your low-cost index funds, but different isn’t always better—it is often worse,” says Todd Rosenbluth, head of research at VettaFi. “The data are pretty consistent that you’re better off replicating a benchmark than trying to beat it. But investors don’t want average returns; they want better-than-average returns.”
So far this year, they have a better chance of getting what they want. But analysts caution investors that paying too much attention to short-term performance can lead to picking poorly managed funds that simply had a lucky surge, while overlooking sold long-term performers that may be having a temporary setback.
Consider BNY Mellon Income Stock (MPISX). Its deep-value tilt caused the fund to rank toward the bottom of its category in 2017 and 2020. But patient and discerning investors who stuck with the fund over the long term have been soundly rewarded. The portfolio has outperformed its Morningstar U.S. Large Mid Broad Value index benchmark and its category average in trailing one-, three-, five-, 10-, and 15-year periods through June 30.
“Short-term performance is random. Long-term performance is not,” says Leuthold’s Opsal, who adds that the best indicator of long-term outperformance isn’t superstrong returns. “To get in the top peer group in the shorter term, managers have to take big risks, and then it’s almost as sure as rain that they will then end up in the bottom decile, too.”
Opsal’s research shows that the most talented managers—those with consistent outperformance—are usually in the 20th or 30th percentile when markets are in their favor, and around the 60th or 70th percentiles in bad years. “Over time, these funds’ returns will compound and gravitate to the top quartile.”
That’s certainly worth the wait.
