Which is best: passive management or active management? It's a seemingly simple question that should be analytically testable. However, when you dig a little deeper, the many layers to this debate quickly become apparent. The honest statistical answer is that there have been oscillating periods when active management has outperformed and under-performed against average market indexes. In fact, the only consistent trend when researching this topic is that passive funds charge investors less for the trouble.
Framing the Active Vs. Passive Debate
The active versus passive debate boils down to one factor: Does the fund manager believe he can outperform the fund's underlying index?
Managers of active funds utilize high stock turnover – frequently buying and selling stocks – to jump out of falling assets and into gaining ones. It's a form of highly diversified arbitrage. Passive managers simply track major market indexes and keep stock turnover – and the fees that come with it – low. The passive approach assumes that markets are efficient and that fund expenses only get in the way of compoundable returns.
All mutual funds and exchange-traded funds (ETFs) are managed and advised to some degree. Even indexed funds cannot always fully replicate the portfolio of their underlying indexes, so managers have to determine how to fill in the gaps.
The 21st Century: A Passive Era
Passive fund management started out as an academic concept in the 1970s and didn't really gain traction until Vanguard burst onto the scenes with its low-cost indexed fund products. By 2000, however, passive funds had become all the rage with investors who had seen almost a decade of market underperformance by active managers.
Ever since, the entrenched position of many is that active funds are never going to consistently beat the market and, more importantly, their high fees are only going to dilute investor returns. There is some evidence of this belief: On a 10-year basis ending in 2013, fewer than half of active managers outperformed the index. Those who did outperform did so only barely – most by less than 1% – and charged higher-than-average fees for the luxury.
Distribution of Returns and Volatility
In separate studies between 2009 and 2014, Vanguard research shows that the distribution of returns among active managers was much more pronounced. Some managers are very good at what they do, while others are very poor. For example, between 2004 and 2014, 50% of active mid-cap growth funds outperformed the style benchmark; only 7% of active mid-cap value funds outperformed their respective style benchmark.
This kind of volatility is an underappreciated menace for long-term investors. Passive funds gain an edge by virtue of simply being more consistent on the aggregate.
U.C. Berkeley Study on Emerging Markets Fund Management
In 2012, advisors and research analysts from the University of California, Berkeley used econometric techniques to test the influence of active management for U.S. equity investors. The team used data from TD Ameritrade Research and the Standard and Poor's NetAdvantage database on "all existing U.S. mutual funds and ETFs dedicated to emerging markets."
Results from the study demonstrated that, before taxes and net of fees, actively managed mutual funds yielded 2.87% higher than passively managed funds over a three-year period. The research team described this as "a striking result."
Taxes don't improve the situation much for the passive crowd. Passive funds still trailed by 2.75% after the regression analysis was adjusted to account for the impact of taxes on net returns.
This study highlights an important debate that doesn't get enough attention: Is active management suitable for some sectors or segments, but not others? There isn't an obvious answer yet, but it seems to be a reasonable question.
Do Most Active Funds Actually Underperform?
The Berkeley study points out results from several other studies, indicating that nearly all mutual funds underperform the S&P 500, net of fees. These largely refer to dual 10-year studies that concluded in 1999 and again in 2003, each of which found that active managers, net excess returns, under-performed the market 71% of the time.
Lesser known are two 10-year studies that concluded in 2008 and in 2013 that showed drastically different results. These studies, produced by Vanguard and Morningstar, showed that the annualized excess returns of active funds beat the U.S. stock market 63% of the time (2008) and 45% of the time (2013). These studies suggest that active funds were worse than the market 71% of the time from 1989 to 1999 but better than the market 63% of the time from 1998 to 2008.
The Vanguard study pointed out that performance leadership among equity groups shifted "from growth stocks to value stocks and from larger stocks to small" between 1999 and 2008 – two items that should benefit active portfolio construction. In fact, value stocks beat out growth stocks by 35% in this period; small-caps beat large-caps by an astounding 43%. These patterns mostly continued from 2008 to 2013.
Someone who says that passive managers often perform better than active managers would be correct. However, someone who responds that active managers often perform better than passive managers would also be also correct.
Just look at the data: In the 25 years between 1990 and 2014, more than 50% of active large-cap managers bested the returns of passive large-cap managers in 1991, 1992, 1993, 2000, 2001, 2002, 2003, 2004, 2005, 2007, 2008, 2009 and 2013.
Over the same period, more than 50% of passive large-cap managers performed better in 1990, 1994, 1995, 1996, 1997, 1998, 1999, 2006, 2011, 2012, 2013 and 2014. (2003 was about even.)
There have been dramatic swings in both directions. In 2011, passive managers showed better returns 88% of the time. By 2013, active managers performed best 81% of the time. In the past three years, things have shifted back into the favor of passive managers. However, these studies use extreme aggregates that deal with thousands of funds; it's likely that some active managers might almost always outperform indexes, and it's likely that some almost always underperform.
In the debate of what money management style performs best, it seems that the answer varies from year to year. There is only one statistical constant in this battle: passive funds tend to charge much less in overhead costs. This may or may not be an important issue for an investor, but it's the only constant in all the research on these management styles.
UC Berkley Economic Research: http://econ.berkeley.edu/sites/default/files/Kremnitzer.pdf