Despite the overwhelming academic evidence demonstrating the superior, long-term performance of index funds, investors may want to invest in actively managed products. New research shows the importance of choosing low-cost funds.
David Nanigian, author of the study, “The Historical Record on Active versus Passive Mutual Fund Performance,” published in the April 2022 issue of The Journal of Investing, contributes to the literature by examining the performance of active managers from a new perspective. He began by noting: “A plethora of studies have documented the fact that mutual funds with higher expenses have lower performance. … This has led to a belief that a passive investment strategy beats an active strategy and the resultant rise in the popularity of index fund investing.” Given the evidence that suggests higher expenses are a main or sole source of the underperformance, Nanigian examined the performance of passive funds against that of comparable active funds whose expense ratios were closer to those of passive funds (such as Vanguard’s actively managed funds) – those in the bottom quintile of expenses.
Nanigian sorted funds into two groups: passive (funds classified by Morningstar as either index funds or enhanced index funds) and active. His data sample covered the period 1991-2019. Fund performance was evaluated based on the Carhart four-factor (market, size, value and momentum) model.
Economic theory suggests that if markets are efficient (meaning the current price is the best estimate of the fair value), active managers are unlikely to outperform on a persistent basis because of their higher expenses – not because they are not skilled. The reason that index (or the broader category of passive) funds outperform is simply due to their lower expenses. Thus, if markets are perfectly efficient, the only difference in risk-adjusted returns between active and passive investors should be their total expenses (not just their expense ratios but trading costs as well).
However, the empirical evidence demonstrates that the markets, though highly efficient, are not perfectly efficient – there are many well-documented anomalies, such as the poor performance of stocks with lottery-like distributions (e.g., small growth stocks with high investment and low profitability, penny stocks and stocks in bankruptcy). While index funds might include these stocks, active managers can screen them out (as do the structured, systematic funds of families such as Avantis and Dimensional). In addition, the evidence demonstrates that retail investors are “dumb money” – the stocks they buy go on to underperform, and the stocks they sell go on to outperform. Thus, there are victims who can be exploited. There is also a large body of evidence demonstrating that retail investor sentiment can skew the demand for securities, which in turn causes prices to deviate from their fundamentals. By trading against the anomalies, active investors could outperform if their costs are not excessive.
When Nanigian compared the performance of all active funds, he found that on an equal-weighted (EW) basis, the active funds underperformed passive ones by 0.43% per annum, though the difference was not statistically significant (t-stat = -1.01). On a value-weighted (VW) basis, reflecting the total returns investors earned, active funds underperformed by a statistically significant 0.83% (t-stat = -2.44).
To create a more apples-to-apples comparison, Nanigian then compared the performance of the passive funds to active funds in the bottom quintile of expenses. Over his sample period, between 29% and 47% of the dollars invested in actively managed funds were also invested in funds that ranked in the bottom quintile of expense ratios. On an EW basis the active funds in the lowest quintile of expenses underperformed by just 0.12% (versus -0.45% for all active funds), and on a VW basis they underperformed by just 0.19% (versus -0.30% for all active funds). In neither case was the underperformance statistically significant.
Taking his analysis one step further, Nanigian examined the performance of the active fund with the expense ratio closest to the passive fund in the same Morningstar style box. The mean and median absolute difference in expense ratios between each index fund and its active “partner” was just 2 basis points and 1 basis point, respectively, indicating that the passively managed funds were paired with actively managed funds that had very similar expenses. Although the difference in performance between the two portfolios was not statistically significant (t-value of 1.55), the portfolio of passively managed funds underperformed its active fund partner by 0.66% per year (-0.14% vs. 0.52%).
One explanation for this finding is that the active funds were able to exploit market inefficiencies given the lower hurdle they had to overcome because of their relatively lower expenses. Another is that the active funds could have had greater exposure to factors not included in the Carhart four-factor model (specifically profitability). A third explanation is that while pure index funds have their advantages, indexing has some negatives that can be minimized, if not eliminated, by intelligent design. Those weaknesses, which result from the desire to minimize what is called “tracking error” or more accurately “tracking variance” (returns that deviate from the return of the benchmark index), include:
- Forced transactions as stocks enter and leave an index, resulting in higher trading costs.
- Risk of exploitation through front-running. Active managers can exploit the knowledge that index funds must trade on certain dates. Structured portfolios (those of fund families such as AQR, Avantis, Bridgeway and Dimensional) that are not concerned with tracking variance avoid this risk by not trading in a manner that simply replicates the return of the index.
- Inclusion of all stocks in the index. Research has found that very low-priced (“penny”) stocks, stocks in bankruptcy, extreme small growth stocks and IPOs have poor risk-adjusted returns. A structured portfolio could exclude such stocks, using a filter to screen them all out.
The performance of high-active-share funds
Nanigian performed another analysis. He eliminated the “closet index funds” from his active funds database, screening out those active funds whose R-squared was below the median R-squared of all active funds. He found that on an EW basis, the high-active-share funds outperformed the passively managed funds by 0.26% (-0.30% vs. -0.56%). However, on a VW basis, the high-active-share funds underperformed by 0.38% (-0.49% vs. -0.10%). In neither case was the outcome statistically significant.
Nanigian then examined the performance of the high-active-share funds that were also in the bottom quintile of expenses. Once again, he found that while the EW high-active-share, low-expense funds outperformed (0.68%), the VW portfolio underperformed (-0.08%). In neither case was the finding statistically significant.
Nanigian then compared the performance of high-active-share, low-expense-active funds with their “partner” passive fund. He found that although the difference in performance between the two VW portfolios was not statistically significant (t-stat = 1.55), the VW portfolio of passively managed funds underperformed its “partners” by 0.66% per year (-0.14% vs. 0.52%).
Investor takeaways
There are several takeaways from Nanigian’s study. Much of the historical outperformance of passive relative to actively managed funds is a result of expenses. That is exactly what one should expect if markets are at least highly, if not perfectly, efficient. If investors are going to play the game of active management, they should restrict their eligible universe to those active funds with expenses close to those of the best passive funds. Last, consider restricting your universe to low-cost active funds that also have high active share. However, before jumping to that conclusion, read my February 21, 2022, Advisor Perspectives article examining the evidence from empirical research on the ability of active share to predict future performance of actively managed mutual funds. For example, in their November 2021 study, “Is Active Share Unattractive?” Morningstar found that despite exhibiting greater risk, high-active-share funds failed to deliver superior net-of-fee results in any category. Despite this, active share has become an increasingly popular metric in terms of both reporting and evaluation.
There are some additional factors to consider before using active funds. The evidence from studies such as the 2010 paper, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” has found that there is no persistence in active fund performance beyond the randomly expected – past performance is not a predictor of future performance. With active funds, there is always the risk that a fund will “style drift,” causing the investor to lose control of their asset allocation – by far the most important determinant of the risk and return of a portfolio. Most active funds, especially those with high-active share, will be far less diversified than index or other passive strategies – they take more idiosyncratic risk, exposing investors to greater potential dispersion of returns without any statistically significant evidence that they will be compensated for accepting that risk. And finally, for taxable investors, the higher turnover of most active funds creates another hurdle in the form of returns lost to taxes.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
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Despite the overwhelming academic evidence demonstrating the superior, long-term performance of index funds, investors may want to invest in actively managed products. New research shows the importance of choosing low-cost funds.
