Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.  

Jayamanne: So, Mark it was recently your birthday – happy birthday.

Mark LaMonica: Thank you.

Jayamanne: What did you do for it?

LaMonica: Well, I went to lunch with you on my actual birthday which was very nice. We went to Bistecca.

Jayamanne: We had the candle.

LaMonica: You bought me a steak, we ate the candle, you forced me to drink red wine.

Jayamanne: Was that just awful for you?

LaMonica: No, it was great, and it was very generous of you so thank you very much. And then I had a couple friends show up at the pub the next day, and we were laughing about this before. One of my friends gave me a recycled card – now not recycled as in materials to make it will recycle. She literally cross out her name and wrote my name – it was a card to her - and then crossed out her mother and father in laws names and put her name and her husband’s name in.

Jayamanne: Thoughtful.

LaMonica: Yeah, thoughtful is not exactly how I would describe it but somebody asked me if she was really environmentally conscious and I was like no, just lazy but anyway. We’re not going to talk about my birthday today because it’s depressing. We’re going to talk about article and passive funds Shani.

So, we’ve done a few episodes that explore the difference between active and passive funds, but today, we want to focus on new research conducted by Morningstar that looks at why active managers underperform. The purpose of this research is to identify common characteristics of underperformance, and from that, investors can hopefully garner insights that they can put to work when picking active managers. 

Jayamanne: That’s right Mark. One of the largest ongoing debates in investing is whether investors should go for active or passive management when investing in funds. In the recent past, we’ve seen investors vote with their funds and passive has had major inflows compared to active funds. 

LaMonica: Although overall, active managers still hold a larger piece of the pie, passive funds are gaining quickly on their active counterparts. When we look to the U.S., passive equity fund ownership is already the majority, with funds under management passing the halfway mark at the beginning of 2022.  

Jayamanne: You gave a great introduction to the report, but it’s worth mentioning that the research conducted focuses of the underperformance of active managers in a particular sector – US large growth. Although it focuses in on this one sector, there are lessons we can take from this report that applies to all sectors when choosing active management.  

LaMonica: In the recent past, passive has proven its competitiveness through superior returns in ‘large growth’. Four equities in particular – Apple, Microsoft, and Alphabet, have provided eye watering returns since the end of the Global Financial Crisis.  

Jayamanne: You always make me do the numbers, Mark – so let’s split these in half. From 1 January 2009 to 4 April 2023, Apple has returned 5,351%, Alphabet has returned 1,256%, Amazon has returned 3,895%. 

LaMonica: Microsoft returned 1,562%. The S&P 500 has returned 356% in the same period. If we look at the cumulative return prior to the most recent downturn, the four stocks hit 1000% growth at the beginning of 2022. At the same time, the Russell 1000 had just cracked 400%.  

Jayamanne: Their inclusion (or exclusion) in funds have largely determined large-growth fund performance relative to their indexes.  

LaMonica: And it seems that conventional wisdom has now become that capturing the average through passive funds and ETFs is better value for an investor. Contributing heavily to this school of thought is that investors typically have paid high fees to active managers. This is an unnecessary drag on returns. So Shani, is this the case, and is it the only contributing factor? 

Jayamanne: So let’s dive into the research, then, we can pick out a few lessons for investors that we’ve coupled with context from the Active Passive Barometer research. We touched on one of the perceived culprits of active management underperformance – fees.  

LaMonica: The report looked at the impact of fees. From 2013-2022, higher fee funds tended to do worse. Of the funds that beat the index, two thirds charged below-average fees, proving that fees were definitely a headwind for active managers.  

Jayamanne: And as investors became more cost conscious, and there were more active managers competing against each other, the fees were brought down. Asset managers have slashed the price for the typical actively managed large growth fund by nearly 40% over the past two decades.  

LaMonica: The report declares that as mentioned, fees were definitely a headwind, but not the root cause of lackluster results. They can see this by looking at the before-fee returns over the past decade, which also struggled to compete against the index.  

Jayamanne: What the report also found was that the success rate of actively managed funds in this space have become less successful over time. From 2000 to 2010, 60% or more of them often beat the index over a given five-year period. In 2022, less than one fourth of active funds had beaten the index over the trailing five-year period.   

LaMonica: Some researchers say that this reflects an increasingly competitive market. The report from Morningstar states ‘It is tempting to conclude that managers have become inept due to the slide in measures of outperformance and success, but arguably the opposite is true. Just as it has gotten harder for individual runners and swimmers to differentiate themselves from their rivals as the average speed and skill levels of athletes have increased, it has become more difficult for highly educated, experienced, diligent, and well-resourced managers to beat their similarly endowed, seasoned, and motivated rivals.’ 

Jayamanne: It also offers another explanation – that amateur investors are much less involved in direct equities, and competition for alpha now happens primarily between highly sophisticated institutional investors that make large cap companies efficiently priced, without space for investors to bag a mispriced opportunity. 

LaMonica: The other factor that a lot of professional investors blame is– cash. Fund mandates stipulate permissible ranges for the allocation of assets. The curse of fund mandates is that some force fund managers to hold cash, or, offer the temptation of holding cash. For example – if we look at a passive S&P 500 ETF, it will be in 100% US equities. If we look at an active fund, the fund may be able to hold 80-100% equities, and 0-20% cash. Some have even stricter mandates which handicap active managers, such as having a 10% mandatory cash holding. The logistics of operating an active fund is that you buy and sell assets and a product of this is that you will be holding cash. Having many investors also means that funds hold cash in anticipation of redemptions as well.  

Jayamanne: This cash holding can handicap active manager performance especially in the bull market that we’ve experienced since the end of the GFC.  If this is true, then the opposite must be true as well – that active managers would have better relative results during bear markets, where active managers can use cash to mitigate risks that the index can’t avoid.  

LaMonica: What the report found was that the cash that active managers hold does hinder their upside, but that shouldn’t explain long-term underperformance. Typically, they hold less than 2% cash. A hypothetical portfolio of a Russell 1000 Growth-Tracking ETF and 4% cash rebalanced monthly would still have done better than the category average and with milder volatility. 

Jayamanne: Large-growth managers’ funds haven’t offered much downside protection or milder risk profiles. In the last decade, the category average lost less than the Russell 1000 Growth in only about half the occasions the benchmark dropped 10% or more; the category’s median standard deviation also has often exceeded the index’s.  

LaMonica: Most large-growth managers embraced more-volatile stocks that tend to fall harder in drawdowns. Controlling for other factors, such exposure hurt the funds’ results as volatile stocks underperformed the broad market during the decade. 

Jayamanne: So, cash is a headwind in some markets, but should not be blamed for underperformance when an index with cash can replicate the same conditions, but with better returns. Alright – so we’ve found that cash is not, or should not be a contributor to underperformance, and fees were a headwind but not the sole contributor. Where have active managers fallen down? Let’s look at other contributing factors. 

LaMonica: The first is style. When we look at large growth stocks, they could be a headwind themselves. When we look at the period between 2013 and 2022, US large growth cap stocks outperformed. However, active managers don’t tend to invest solely in one particular style. Active large-growth funds for example, tend to own more stocks with lower earnings-growth expectations, cheaper valuations, smaller market-capitalisations and greater international exposures than their benchmarks. 

Jayamanne: This means that they perform differently to the benchmark, and if one particular style has performed better than others, that strategy can dilute returns. 

Okay – let’s just call this one out. Bad stock picking.  

LaMonica: The report conducted risk-based attribution analysis of each active large growth fund’s style exposure showing that actively managed funds tended to be more narrowly focused than the index on fast growing companies with high price multiples and low dividend yields. 

Jayamanne: They also tended to tilt towards smaller cap companies that did not provide any advantage over the last decade. The results were similarly mixed when international stocks outperformed U.S. 

LaMonica: The bottom line is that when the report controlled for funds’ style and sector exposure, Morningstar’s risk model suggests that a hefty amount of the large growth fund’s poor showing versus the benchmark was simply because of bad stock picking. 

Jayamanne: The results cast a harsh light on active managers. There is a legitimate reason to consider cutting them some slack – the phenomenal results of a handful of huge benchmark constituents that have left stock-pickers few ways to beat the index. 

LaMonica: Again, we arrive at the four tech behemoths – Apple, Microsoft, Amazon and Alphabet. They were one third of the Russell 1000 Growth’s 14% annualised gain from 2013 to 2022. 

Jayamanne: If we look at the US specifically, the Investment Company Act of 1940 says that if mutual funds want to call themselves diversified, they can have no more than 25% of their assets in individual positions of 5% or more. Each of the four stocks account for more than 5% of the index. This means that even if these funds wanted to, it is extremely difficult for them to shadow the index to replicate these returns.  

LaMonica: This seems like an argument for passive funds. Own the index and you’ll get stellar returns. But – there are risks. 

Jayamanne: The first is concentration. Company specific risk is not endemic to the US. Australian markets face the same issue with the largest constituents in our stock market holding a huge piece of the pie. If we look at the S&P 500, the top ten holdings make up over 27% of the index – out of 500 stocks. If we look at the S&P ASX 200, it’s over 46% (as at 4 April 2023). Even high conviction active managers are concerned about the concentration, and the risk that is then embedded in the index. 

LaMonica: Then, there’s maintaining growth. Most companies that approach the size of these ‘Benchmark Behemoths’ struggle to maintain the breakneck growth that they have experienced. It is difficult to sustain and maintain the innovation and keep competitors at bay. Without context, it seems like these companies have staying power. What we have seen over history is that a company’s index dominance is often temporary.  

Jayamanne: Let’s have a look at how an index, the Russell 1000 Growth has changed over ten year periods.  

LaMonica: In 2002, the top 10 – General Electric, Microsoft, Pfizer, Johnson and Johnson, Walmart, Intel, Cisco, Coke, Pepsi, Merck and Co.  

Jayamanne: In 2012 – where was the leader? General Electric? Not in the top 10. 7 of the holdings in 2012 were new entrants. Apple was ranked at the top of the leaderboard by marketcap, and didn’t even make an appearance in 2002.  

LaMonica: Fast forward another ten years to 2022. Apple maintained its top spot, but it’s followed by Microsoft and Alphabet, both new to the top 3. Amazon is 4th and wasn’t in the top ten in 2012. Again, 7 of the top ten companies are new to the top 10. 

Jayamanne: What we’re trying to show from this is that we always think that the companies with the highest market cap has staying power, but the past has shown us that this isn’t true.  

LaMonica: That’s right Shani, we cannot guarantee that in the future this will happen. In the past however, underweighting these large stocks have helped diversified large growth funds when the benchmark’s largest holdings perform poorly, but hurts when the biggest stocks do well, as they did for many years before 2022. Let’s move onto some lessons for investors, but first, let’s give a bit of a recap of the Active Passive Barometer, because the context is important.  

Jayamanne: Morningstar publishes a report twice a year called the Active Passive Barometer report. This report spans nearly 4,400 unique funds that account for approximated 15.9 trillion dollars in assets. The purpose of this research is to give investors a useful measuring stick that helps them calibrate the odds of succeeding with active funds in different categories. 

LaMonica: It measures the performance of U.S. active funds against passive peers in their respective Morningstar categories. Although this report focuses on funds, the same concept applies to any collective investment vehicle with a professional manager – so in other words, ETFs. 

Jayamanne: Although this is a US-based study, at a high level, US and Australian fund managers largely face the same challenges and operate in very similar ways. Apart from local markets, both US and Australian fund managers would have the same coverage universe for other sectors and markets. 

LaMonica: Funds where active managers performed better than passive peers includes international funds. The majority – 61% of active foreign stock funds outperformed their average passive peer. Then we have 73% of active real estate funds beating their average passive peer during 2020, and we’ve seen a trend of active mid and small cap funds succeeding more often than active large cap managers.  

Jayamanne: There’s a reason for this. All these sectors have something in common, and that is that they’re not as well researched or as well covered as the sectors where passive tended to do better. Ultimately, it is correlated to how efficient the underlying market is.  

LaMonica: The degree of efficiency relates to how much the prices in that market reflect the underlying valuation. Markets tend to be more efficient when there’s widespread investor interest and coverage of that market. This is where we see this research intersect with the performance of the large-growth active managers studied in ‘The Big Shortcoming’ Report. 

Jayamanne: Alright, a few lessons - The research shows that you do not need to sit in either the active, or passive camp. Passive funds may suit well-researched markets that are efficient. 

LaMonica: Where active managers can add value are in broad and varied markets. Markets where there may be inefficiencies that create opportunities. There are also places where active managers can add value based on what you are trying to achieve. The concentration risk that the large companies in Australian and US indexes brings may not suit your risk and return profile. Low volatility, income focused or real return managers may be able to suit the goals of your portfolio.  

Jayamanne: Both reports stress the importance of keeping fees low. Active managers can add value in the right places in your portfolios, but ensure it is at the right price. The Active Passive Barometer report explores this in detail. It slices the coverage universe into fee quintiles to highlight the difference that fees make. When they look into 10 year success rates of funds (how many active funds beat passive counterparts), in every single category, the lowest cost quintile beat the highest cost quintile when looking at average success. 

More expensive fees do not equate to better quality, or more skill.  

LaMonica: The Big Shortcoming Report is available on Morningstar Investor, and it also goes further into depth about the impact of fund manager performance on flows – if that is something that you are interested in.