the dilemma of active management | The morning star


The math problem
The first thing most novice investors learn is that it’s best to buy index funds. This is a good place to start. Morningstar tracks the performance of actively managed funds against relevant indices for 20 of the largest fund categories. In 17 of these 20 categories, the average actively managed fund failed to keep pace with its benchmark for the decade 2010-19. Of course, there were many exceptions, but the generalization is generally correct.

The explicit problem with active management is that when it charges for its services, those costs hurt its product. Paying more for a car, vacation, or school fees doesn’t change the nature of that car, that trip, or that education. In contrast, higher expense ratios directly and irreversibly reduce investment performance. If the funds were sports cars, the higher their price, the slower their acceleration. A Lamborghini would struggle to overtake a golf cart.

This logic has become so familiar that it is considered trivial – which it is, strictly speaking. However, it should be noted that most investors believed the opposite for several decades. In 2001, a financial planning magazine asked its subscribers to rank the importance of various fund attributes. Spending ratios ranked seventh.

Forced to explore
The implicit problem of active management is less appreciated. If investors reject the higher costs of active management when cheaper index funds are available, then active managers should go where indexers are not. Their strategies become limited. Indexers can create any variety of funds, but active managers are limited by the market. They are forced to move away from ordinary vanilla and turn to the exotic.

This situation existed long before index funds were a threat. In the 1980s, the key battle was not between active and passive funds, as the latter barely existed, but rather between funds with and without fees, i.e. funds sold by financial advisers. and funds that investors would buy directly. The former generally had higher expense ratios, due to integrated sales and / or marketing costs. This put them at a cost disadvantage compared to no-fee funds.

The expense handicap has not bothered those who have marketed dependent equity funds, as the effect that costs have on total returns has not been widely appreciated. at the time. But that was a big concern for those who were selling bond funds. Investors have bought fixed income funds primarily for yield, and the SEC requires mutual funds to pay their expenses out of income (if they have any), not out of capital. Thus, no-fee bond funds paid lower monthly dividends than their no-fee competitors. Investors have noticed this, forcing load fund sponsors to respond, or lose business.

Product management was up to par. The major loading fund companies quickly launched “government plus” funds, which sold call options on their long-term treasury bills and then distributed the option proceeds. Investors initially thought government funds and more provided a free meal, but eventually realized that their extra “return” was not real income, but rather short-term capital gains. They also began to understand that more government funds inevitably erode their net asset value because these funds keep all of their capital losses, but not all of their capital gains.

Soon after, most government funds went from the best-selling category in the industry to complete extinction. Each government-plus fund has changed its charter or been merged. The pros, it turned out, were the cons. When portfolio managers have done more, they have delivered less.

This pattern has been repeated several times. “Enhanced index funds” were created and then shut down, while the actual index funds remained. The tactical allocation funds arrived after October 1987, disappeared, returned after the collapse of the new era and the financial crash of 2008, and then disappeared again. Do you want to hold an “American Government Bond” fund that supplements its Treasury positions with Mexican and Argentinian papers? Probably not. If so, you’re out of luck. These funds were dismantled a few years after their creation.

A story of two funds
Another example: in the early 1990s, an investment manager under-advised two government mortgage funds. One of the funds was owned by Vanguard and was cheap, while the other was for a fund loading company and was expensive. The two portfolios were radically different. The holdings of the Vanguard fund were conventional. The other fund’s investments weren’t made up almost exclusively of premium coupon mortgages, which (you guessed it) yield higher current returns, but to the disadvantage (you guessed it again) of gradually deplete the fund’s capital base.

The cost difference restricted the portfolio manager’s movement. Had the two funds been structured as clones, the loading fund would have performed below average (as well as consistently and clearly lower total returns than the Vanguard fund, due to the extra ballast in the expense ratio) . Marketing considerations precluded this route. As a result, the manager muddied the waters and increased returns by adopting an idiosyncratic and ultimately unsuccessful strategy.

A fate to be avoided
Although few people today remember the details of these fund-loading misfires, the events were extremely significant. They taught a generation of financial advisers to be wary of complex investment strategies and appreciate the merits of the simpler no-cost funds they had long marketed against. The industry’s shift from selling commission-based investments to billing advisory fees was not primarily driven by product features, but was helped by them.

The challenge for active managers today is how to avoid becoming the next version of dependent funds. They face a similar difficulty, in that their additional costs prevent them from directly facing index funds. Instead, they must define new investment spaces; convince the market that these new spaces are somehow superior to the established routes; and (critically) prove their theses with their performance. All without harming their collective reputation by inventing fund categories that are no worse than those they intend to replace.

It is a tall order. While it may be achievable, history suggests it would not be the way to bet.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler Report, his opinions are his.


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