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At first glance, a new report from Standard & Poor's tells a familiar story: index funds outperform active management, part 37. But a closer look shows that under the right conditions, funds run by a human stock-picker can be well worth their fees.
On the whole, S&P's "Scorecard" report doesn't look good for active management. For the five-year period ending June 30, indexes beat the majority of actively managed funds in 11 of 13 domestic stock fund categories; they also won out over domestic funds overall. The indexes triumphed in three out of four international stock fund categories, and in 12 out of 13 fixed-income categories. In some cases, it's not even close, with 80 or even 90% of active funds falling behind benchmark indexes.
But in the few places where active funds beat indexing, they won decisively, with about two-thirds of active funds outperforming. Pick the right spots, says Aye Soe, a director of global research at S&P, and "there is value in active management."
Whether actively managed funds can reliably beat their indexes has more to do with market trends than it does the skills of managers, especially over periods shorter than ten years, says Dan Culloton, the associate director of fund analysis at Morningstar. When a particular category of assets is doing badly in general, actively managed funds in that category often do better, because they have the flexibility to holding cash or sway slightly from their mandate. But when the same category takes off, that flexibility -- or style drift, as it's often called -- can cause an actively managed fund to lag. An index fund, on the other hand, will simply match the returns of the market, which can be a relative benefit in a rally, a detriment in a slump.
The success -- or failure -- of active management may also depend on the sector or category the fund tracks. If the stocks in a sector tend to move up and down in lockstep, it can be difficult for active managers to get an edge, Soe says. A sector where the stocks behave very differently, on the other hand, offers more scope for skilled stock-picking to pay off.
Similarly, it may be easier for active managers to get an edge in smaller, less widely followed markets. The idea is that in big, transparent, competitive markets, anything there is to know about a given stock is immediately reflected in its price. "The more people there are battling it out over price, the fewer surprises there are going to be," Culloton says. In a small market with fewer investors, "you're more likely to find a hidden gem," he says.
Over periods of ten years or more, indexing tends to win out -- not because there are no talented active managers, says Fran Kinniry, a principal in Vanguard's investment strategy group, but because indexing is cheaper. The average actively managed stock fund, including international funds, charges 1.45% per year, or $145 per $10,000 invested. That's double the price of the average stock index fund, according to Morningstar. Over time, that's enough of a difference to give index funds an inherent advantage.
Here are four areas where active management looks particularly good, or particularly bad, in S&P's latest scorecard:
Winner: Active
The average actively managed international small-cap fund returned 4.91% per year over the last five years, more than triple the index. And only 23% of these funds fell behind benchmark indexes in the past five years, and the score was pretty similar at this time last year. It seems that shares of international companies with less than $2 billion in market cap have a wider range of returns than other kinds of companies, which creates more opportunities for active management, Soe says. "If everything moves together, there's not much added value for an active manager," she says.
Winner: Active
More than half of actively managed large- and small-cap value funds beat the benchmarks in the past five-year period. Actively managed large-cap value funds did particularly well, returning 2.2% per year on average, versus 0.63% for the index; actively managed small value funds earned 3.79% per year, versus 2.96% for the index.
That's new, compared to a few years ago, when these funds were broadly losing to their benchmarks. Value investors typically look for stocks that look cheap, often ones that pay a dividend, which tends to include a lot of financial stocks. That spelled dismal performance for the group overall in 2008, which perversely helps make actively managed funds look better than the indexes in the past few years, Culloton says. Any value manager who deviated from a pure value mission, either by holding cash or more growth stocks, would have helped active managers beat indexes in 2008. No such luck for an index investor.
Winner: Tie
Emerging-market stock funds fell way behind their benchmarks in the past five years: Only 13% of actively managed funds outperformed, and the average fund underperformed considerably. The index returned an average 12.05% per year over the last five years, compared to 9.44% for the actively managed category. Emerging-market stocks tend to move up and down together as a more uniform group, leaving less room for active managers to separate winners from losers, Soe says.
On the other hand, emerging-market debt funds fared better, with about two-thirds of active managers beating their indexes. Some global bond indexes give more weight to bigger issuers of debt, which essentially means heavily indebted countries with shakier finances make up more of these indexes, Culloton says. That means "it's been sort of an easy call for managers just to invest in the countries with better balance sheets," he says.
But average performance figures among emerging-market bond funds show how important it is to pick the right actively managed fund. The index returned 9.51% on average per year over the past five years, better than the average 9.4% for actively managed funds -- return figures that imply that the actively managed funds that failed to beat the index did poorly enough to drag down the average for the rest of the category.
Winner: Passive
Indexes beat the majority of bond funds of all types over the past five years -- 80% of long-duration government bond funds failed to do better than the benchmark, 84% of long-duration investment-grade funds fell short, and 92% of high-yield funds underperformed. Morningstar analysts say that many core bond fund managers have assembled portfolios that look significantly different from the indexes, in attempts to boost returns and protect against interest rate risk. They're diversifying away from government debt, buying higher-yielding bonds, and sticking to shorter durations. That means active performance will be very different from index performance, for better and for worse, and active funds' current portfolios look particularly bad in periods when Treasuries are rallying. For high-yield funds, this data likely shows active managers prudently avoiding some of the riskiest junk bonds, which rallied strongly in 2009, says Morningstar analyst Eric Jacobson. Some of these bond fund categories include a relatively small number of funds, Kinniry notes, which means it may take only a few funds to tip the scales between active and passive management overall.
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