Morningstar Magazine - June/July 2017 - 13

Across the Board

The Journal's reporters, as with most who cover
the subject, focused on U.S. equity funds.
Those figures were, shall we say, unhappy.
That study, "SPIVA U.S. Scorecard" (by S&P Dow
Jones Indices), found that more than 90%
of actively run U.S. diversified funds trailed their
benchmarks for the past 15 years.
Contrary to the popular belief that active
management makes more sense when buying
small companies than when purchasing heavily
researched blue chips, the SPIVA report found that
active large-company stock funds fared best.
Although best in this case meant "least awful,"
with 92% of large-company funds falling short of
their benchmark, as opposed to 93% for smallcompany funds and 95% for those funds investing
in mid-caps. So much for the conventional wisdom.
The paper then examines other asset classes
and finds similar lack-of-success rates.
Ninety percent of emerging-markets stock funds
failed to match their benchmarks. For
intermediate-government funds the figure was
82%, and for general international-stock funds 89%.
Thus, while the common story is that active fund
managers struggle to beat the S&P 500, or perhaps
the U.S. stock market overall, the victory for
indexing extends far more widely than that. In
every category that the SPIVA paper examined, the
benchmark triumphed for the 15-year period. There
were no exceptions.

when attempting to assess performance.
One must also take into consideration those funds
that have since departed. To ignore the dead
is to bias the results upward, because almost
surely the funds that were terminated were, on the
whole, less successful than those that their
companies chose to keep alive.
Nonetheless, a failure caused by performance
is not the same as one caused by liquidation. With
the former, the investor absolutely, positively
would have been better off holding the benchmark.
With the latter, we do not know. We know
that the original fund ceased to exist, thereby
freeing up monies to be reinvested elsewhere. It is
quite possible that those assets were put to
good use. Our assumption is universally negative;
however, the actual outcome is not.
The survivorship hurdle has a huge effect. For
example, only 34% of U.S. large-company funds
finished the 15-year period. The numbers are
higher for most other categories, particularly
municipal-bond funds; overall, only about
half of all funds lasted 15 years. Thus, the success
rates among those funds that persisted are roughly
double the rate that the study suggests.

Using only lowest-cost funds, and reducing
the time horizon to 10 years, gives a rather different
picture. In seven of the 12 categories that
Morningstar evaluated, the actively managed
funds either won the contest by scoring
success rates of greater than 50% (mid-value U.S.
stock, diversified emerging-markets stock,
intermediate-term bond), or posted competitive
results that exceeded 40%.
In Summary

Steve Romick and FPA have shown how to win
at active management: Be different than the
indexes and execute, execute, execute! But Romick
is the exception.
Actively managed funds as a whole have struggled
and are attracting few new assets. The Journal's
story-and the research behind it-showed why.
Too many actively managed funds fold, and, unlike
FPA Crescent, most of the rest cannot overcome
the performance drag of their expenses.

Costs Matter

That silver lining, of course, is more lining than
silver. Having many funds expire along the way,
with those that do survive still generally lagging
the benchmark, is not a glorious achievement. But
there is a way to improve the odds considerably-
by sorting on costs.

Live and Let Die

This grim news does carry two positive caveats.

benchmarks over the next decade, 48% of the
lowest-cost funds beat that hurdle. Morningstar's
success rates tend to be higher than SPIVA's
because Morningstar's time period is shorter,
which means that more funds survive.

The first is that those wretched actively managed
success rates are heavily influenced by survivorship bias. In the SPIVA study, any actively managed
fund that existed as of January 2002, and then
merged or liquidated at some time during the next
15 years, is counted as a failure. The only winners
are funds that accomplished two tasks: operated for
the entire 15 years, and outgained the benchmark.

This finding comes not from the SPIVA paper, but
from my own company's April report the
Morningstar Active/Passive Barometer. In that
paper, Ben Johnson and Alex Bryan sorted
actively run funds by their expense ratios. Those
funds that placed in the cheapest quartile
of their category, entering the year that the study
began, were placed into the lowest-cost group.
Conversely, those funds that landed in the priciest
quartile were tracked as highest cost.

That is a valid approach; indeed, I have used
the same logic when evaluating the performance
of the Morningstar Rating for funds. It is not
enough to look only at funds that currently exist

The success rates were universally better for the
lowest-cost funds, usually by large amounts.
For example, while only 22% of the large-value U.S.
stock funds in the highest-cost group beat their

Those things said, actively managed funds have
performed better than the first glance indicates,
particularly for those who own the cheapest funds.
The advice for active management to improve its
fortunes is simple. First, take more care when
opening and closing funds. Throwing investments
against the wall to see what sticks, and
shutting down those funds that don't take hold,
impresses nobody. Second, less is more! The lower
the expense hurdle, the easier it is to jump.
And yes, that prescription sounds much like what
Vanguard does with its active funds, which
rarely (although occasionally) are shut down, and
which invariably carry low expense ratios.
The industry leader follows best industry practices,
which its rivals could benefit from emulating.
Imagine that. K
John Rekenthaler is vice president of research
with Morningstar Research Services.

global.morningstar.com/Morningstarmagazine

13


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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2017

Contents
Morningstar Magazine - June/July 2017 - Cover1
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Morningstar Magazine - June/July 2017 - 1
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Morningstar Magazine - June/July 2017 - Contents
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