Morningstar Magazine - June/July 2017 - 45

actively managed funds have underperformed
their passive counterparts, especially over
long time horizons. They have also experienced
high mortality rates-that is, many more
funds were merged or closed. In addition, active
funds' failure has tended to be positively
correlated with fees, with higher-cost funds more
likely to underperform or be shuttered or
merged away, and lower-cost funds likelier
to survive and enjoy greater odds
of success.
Long-run success rates across actively managed
U.S. large-cap funds have been generally
lower than those among mid- and small-cap U.S.
equity funds ( E X H IB IT 1 ). Even so, less than
30% of the active funds in each of the nine
Morningstar equity categories represented in the
Morningstar Style Box outperformed the category's
passive options over the past 10 years through
the end of 2016. The active funds in the small-value
and small-blend categories were most successful
relative to passive peers, with 29.3% and
28.9%, respectively, outperforming on a 10-year
basis at the end of last year. Meanwhile, just 5.9%
of large-growth funds beat the composite of
index funds, which was the worst record among
the nine Morningstar equity categories measured
by the Active/Passive Barometer.
As we noted, fees differentiate funds and can
help predict which are more likely to underperform
and which are likelier to enjoy greater success
rates. When looking at the nine Morningstar
equity categories represented in the Morningstar
Style Box, it should come as no surprise to see
the lowest-cost actively managed funds perform
better in nearly every category. The biggest
difference occurred with inexpensive actively
managed small-blend funds, where 46% of funds
in the category beat a comparable collection
of passive funds on a net-of-fee basis over the past
decade-a 170-basis-point improvement over
the broader group of actively managed small-blend
funds. Conversely, the collection of more-expensive
actively funds performed far worse than their
passive peers in just about every Morningstar
equity category represented in the Morningstar
Style Box during the past decade, with just
4.8% of more expensive large-blend funds beating
the category's index funds on a net-of-fee basis,

and only 18.4% of pricier small-blend funds beating
a collection of passively managed funds.

The rule as proposed would effectively change the
standard of care for retirement savings advice
from a suitability standard (which requires brokers
and advisors to make recommendations that are
suitable for a client based on that client's
personal situation) to a fiduciary responsibility
(which requires advice to be in the best
interest of the client).

Investors Have Become Cost-Conscious

The key takeaway from the Morningstar Active/
Passive Barometer report is this: Investors
can greatly improve their odds of success by
choosing low-cost funds, which have succeeded
far more often than high-cost funds over the
long run. Investors have wisely migrated to
lower-cost share classes over time. Since 2000,
assets flowing into load and no-load shares
have fallen steadily, while low-cost institutional
shares, ETFs, and retirement shares now
account for about half of the industry's annual
net flows ( EXHIB IT 2 ).

Fund Assets Move to Passive

The growth of index funds and ETFs in the retailadvised channel has been spurred by the secular
shift toward passive investing that began
more than three decades ago. The movement
of more advisors into fee-based structures
continues to play a role in the migration
to low-cost passive investment options, with
the greater scrutiny being put on fees and performance only adding to the shift. At the end
of 2006, just 16% of the industry's $7.7 trillion of
assets (excluding money market funds and
funds of funds) were parked in indexed mutual
funds (11%) and ETFs (6%). By the end of

We expect the emphasis on low-cost share classes
to accelerate in the coming years. The fiduciary
rule, finalized in April 2016 and initially set
to take effect in April (but currently delayed
by the Trump administration), will speed up the
trend toward low-cost investment options.

EXHIBIT 1

Poor Performers Active funds have low success rates of beating their passive
peers, especially over the long term. However, the lowest-cost active funds have
better success rates than the highest-cost funds in nearly every category.
10-Year
1-Year

2-Year

3-Year

Overall

U.S. Large Blend

25.3

19.6

19.8

14.0

22.8

4.8

U.S. Large Value

20.3

7.0

24.9

20.0

24.5

13.8

U.S. Large Growth

29.8

10.1

14.4

5.9

9.2

5.9

U.S. Mid Blend

24.8

20.3

20.0

10.6

7.9

5.4

U.S. Mid Value

19.8

12.2

16.8

21.7

33.3

6.9

U.S. Mid Growth

30.7

32.6

24.9

23.2

29.3

14.9

U.S. Small Blend

36.7

35.7

29.6

28.9

46.0

18.4

U.S. Small Value

15.0

34.6

27.6

29.3

20.0

22.9

U.S. Small Growth

28.4

20.1

18.8

15.6

23.2

7.4

Foreign Large Blend

33.5

43.1

39.8

32.2

44.4

20.5

Diversified Emerging Markets

37.1

61.4

59.1

29.3

42.9

15.0

Intermediate-Term Bond

74.8

53.8

68.4

44.4

56.6

32.9

Success Rate by Category (%)

Lowest Cost Highest Cost

Source: Morningstar. Data as of 12/31/16.

global.morningstar.com/Morningstarmagazine

45


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