Morningstar - Q3 2020 - 12

Dispatches

company U.S. stock funds remain woeful,
but the results for other categories improve. In
many cases, the mode of the distribution
(that is, the most common outcome) is positive.
However, there is a catch: This analysis can be
generated only on funds that continue to
exist. For example, the mode is +1 percentage
point for foreign large-blend funds. That
certainly is good. Yet of all the foreign largeblend funds that entered January 2010,
only 61% survived through December. The other
39% were terminated, most likely while
performing poorly.

EXHIBIT 2

EXHIBIT 3

Active Fund 1- and 15-Year
Success Rates It's easier for active
managers to succeed over the
short term.

10-Year Success Rates by Expense
Quintile Cheaper funds have
an edge but aren't likely to beat the
passive competition.
Success Rate

Success Rate

Cheapest
Quintile

Priciest
Quintile

Large Blend

17

2

12

Large Growth

10

2

58

29

Foreign Large Blend

45

29

Large Value

34

15

Large Value

23

3

Intermediate Core Bond

37

16

Intermediate Core Bond

49

15

Objection 3: What about different time periods?

Diversified Emerging Markets

68

N/A

Diversified Emerging Markets

68

32

Fair enough. E X H I B I T 2 shows how actively
run funds fared for the trailing one- and 15-year
periods. Active funds look much better in the
recent past! In contrast, aside from large-company
U.S. stock funds, their 15-year results are even
worse than their 10-year totals. Viewed in isolation,
one could interpret this pattern as indicating that
active management has long faced headwinds
but now enjoys better conditions.

Mid Blend

58

6

Mid Blend

33

4

Mid Growth

72

29

Mid Growth

41

20

Small Blend

46

17

Small Blend

47

16

Small Growth

75

23

Small Growth

40

20

That could be. But the simpler and more likely
explanation is Jack Bogle's claim: Over the
short term, costlier funds can compete effectively
with their low-cost rivals, thanks to market
fluctuations. But the longer the time period, the
less likely that expensive funds will overcome
their expense-ratio handicap.
Objection 4: If you eliminate the dogs, active
management does fine.

The same might be said of the passive-fund
averages. Nevertheless, the counsel is sound,
assuming that the dogs can be identified in
advance. The most reliable approach is to screen
on costs. Once again, the Barometer provides
the answer, as it sorts active funds by their
expense ratios. The most expensive 20% qualify as
the priciest quintile, while the thriftiest 20%
land in the cheapest quintile.
As shown in E X H I B I T 3 , the expensive funds
perform wretchedly. Removing them certainly does
improve active funds' percentages. However,
even the cheapest active funds weren't quite able
to keep pace with the passive-fund averages.

12

Morningstar Q3 2020

Category

1 Year

15 Years

Large Blend

35

17

Large Growth

44

Foreign Large Blend

Category

Source: Morningstar Active/Passive Barometer. Data from
01/01/2019-12/31/2019 and 01/01/2005-12/31/2019.

Source: Morningstar Active/Passive Barometer. Data from
01/01/2010-12/31/2019.

They narrowed the gap, particularly outside of
their trouble spot of the U.S. large-company equity
categories, but they didn't close it. Once again,
only the single category of diversified emergingmarkets stocks bested the 50% mark.

of active management when cheaper index funds
are available, then active managers must go
where indexers are not. Indexers may create any
variety of fund, but active managers are
constrained by the marketplace. They are forced
away from plain vanilla, and into the exotic.

Forced to Explore

The explicit problem for active management is that
the costs it charges for its services harm its
product. Paying more for an automobile, vacation,
or tuition doesn't change the nature of that car,
trip, or education. In contrast, higher expense
ratios directly reduce investment performance. If
funds were sports cars, the steeper their price tags,
the slower would be their acceleration. A
Lamborghini would struggle to outpace a golf cart.
This logic has become so familiar as to be
considered trivial-which, strictly speaking, it is.
But at one time, most investors believed otherwise.
In 2001, a financial-planning magazine asked its
subscribers to rank the importance of sundry fund
attributes. Expense ratios placed seventh.
Less appreciated is active management's implicit
problem. If investors reject the higher costs

This situation existed long before index funds
were a threat. In the 1980s, the key battle
was between load and no-load funds-that is,
funds sold by financial advisors and funds that
investors would buy directly. The former
typically carried higher expense ratios, due to
embedded sales and marketing fees. This placed
them at a cost disadvantage to no-load funds.
The expense handicap did not bother those
who marketed load equity funds, because
the effect that costs have on total returns was not
widely appreciated at the time. But it was a big
concern for those who sold bond funds. Investors
bought fixed-income funds mostly for yield,
and the SEC requires that mutual funds pay their
expenses from income (should they possess it),
not from capital. Thus, load bond funds paid lower
monthly dividends than did their no-load rivals.
Morningstar - Q3 2020

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