The Active-Passive Debate Revisited
Is it really impossible to find outperforming mutual funds in advance? It depends on where, and how, you look.
Asset flows to passively managed funds are surging. But, as often happens, advisors are embracing a trend just as debunking information is arriving in the marketplace. New research is showing that selecting above-average active funds may not be the impossible task that the academic research has suggested.
Dr. Michael Phillips, one of those spearheading this research, can be fairly accused of living in financial academia, the bastion of research whose studies have convinced many financial planners that it is impossible to reliably outperform passive benchmarks with active investment options. A former economist with the U.S. Department of Commerce, Phillips served as professor of finance at the University of Southern California before taking his current position as chair of the Center for Financial Planning and Investment at California State University at Northridge. He’s has co-authored (with Dr. James Chong, also of Cal St. Northridge) four recent academic articles in the Journal of Wealth Management, plus research reports in the Journal of Derivatives & Hedge Funds, the Journal of Interdisciplinary Economics, the Journal of Corporate Treasury Management and the Journal of Personal Finance.
Two years ago, Phillips was asked by the fi360 organization in Pittsburgh to evaluate the organization’s Fiduciary Scores. This screening tool uses Morningstar data to grade all mutual funds based on nine criteria that would be appropriate for a hypothetical prudent investor. The highest scores are reserved for funds whose portfolio management team has been in place for the past two years; whose portfolios are reliably consistent with the asset class they’re purported to represent; which exhibit high correlation with the performance of that asset class; which have low expense ratios relative to peers; and above-average risk-adjusted performance relative to peers over several time periods. Scores are aggregated, each fund or ETF is given a percentile ranking based on its placement among its peer group and then the results are color-coded. The funds with the highest 25% aggregate fiduciary rankings are assigned a dark green color, and the remaining quartiles are light green, yellow and red for the bottom quartile.
“In all, we looked at a million different observations,” says Phillips, “and tried to determine if the funds in the ‘green’ category would consistently provide better results than the other categories in several dimensions over one-, three- and five-year future time horizons. The fi360 people told us to beat on it as hard as we could wearing our academic hats.”
What Phillips concluded at the end of the project would be surprising to any researcher who believes in efficient markets. “After a lot of analysis, we found that their top grouping, the funds that were colored green, generally had higher returns and lower volatility,” Phillips reports. “If you put your 401(k) or long-term pension plan into the fi360 green or light-green investments, it wound up being an excellent screen. It started us thinking,” he adds, “that maybe there were other tools that could be used to help people find the best mutual funds to buy on a five-year horizon. Sure enough, we found something hidden in the data that nobody could have expected.”
Strong passive fund flows
In the court of public opinion, and particularly in large segments of the financial planning/investment advisor population, the debate between active and passive investing is largely settled. The Brinson, Hood, Beebower research concluded that all kinds of security selection (including attempts to find above-average fund managers) adds almost exactly as much value as market timing. Since around 1965, a variety of research papers by Eugene Fama, Michael Jensen, Christopher Philips, Francis Kinniry and Todd Schlanger – – and most recently, Rick Ferri of Portfolio Solutions and Alex Benke of Betterment (see here) – – have concluded that anywhere from 82% to 90% of actively-managed funds fail to outperform their index benchmarks, with the higher percentages associated with longer time periods. The fact that different funds outperform over different time periods has led to the logical conclusion that luck was more important than skill for at least some of those managers with outperforming track records.
In the past three years, investors have taken this seemingly-settled academic conclusion to heart. Last year, when Morningstar researchers calculated asset flows into actively- and passively-managed stock and bond funds, they found significant outflows from active and significant inflows into passive. (See exhibit 1.)
The 2015 Investment Company Institute (ICI) Fund Factbook suggests that this is actually a very recent phenomenon. Net new cash flow to index funds climbed incrementally from $56 billion in 2009 to $59 billion in 2012 before exploding to $114 billion in 2013 and $148 billion last year. Add $800 billion in cumulative outflows from actively-managed stock funds since January 2007, and you find that index funds now make up 20.2% of total equity fund assets – – and that figure doesn’t count $2 trillion in ETF assets under management.
According to a recent PWC research report (Asset Management 2020), if present trends continue, assets in actively-managed mutual funds worldwide will increase by 30.5% between now and the year 2020, while passively-managed funds will experience a growth rate ten times higher, of just over 300%.
New research challenges whether those asset flows will be misdirected. It falls into two categories: identifying time periods and asset classes where active managers are easier to spot and/or add more value; and identifying better search criteria and better data than the relatively simple returns models used by academia.