While the philosophical debate continues to rage on about the merits of active management, we’d rather focus on the data. After all, it’s the data that drives our decision-making process as retirement plan advisors and fiduciaries.
Morningstar, an independent provider of investment research, publishes a semiannual report that analyzes the performance of active strategies against a composite of index funds, net-of-fees. The goal is to create an apples-to-apples comparison of how the average dollar invested in various active strategies compares to low-cost, indexed alternatives. Their dataset covers funds with roughly $13 trillion in assets, nearly 70% of the U.S. fund market. Morningstar calculates active manager “success rates” by category which shows the percentage of funds that have outperformed. From the table below, you can see the results are consistent (and bad).
Active Funds’ Success Rates by Category
| Category | 1-Year | 3-Year | 5-Year | 10-Year | 15-Year |
| U.S. Large Blend | 31.1% | 15.5% | 16.4% | 10.9% | 13.9% |
| U.S. Mid-Blend | 31.4% | 19.3% | 17.9% | 11.9% | 7.8% |
| U.S. Small Blend | 21.3% | 21.2% | 19.0% | 24.9% | 17.1% |
| Foreign Large Blend | 18.5% | 25.4% | 32.8% | 24.5% | 28.4% |
Source: Morningstar Data and Calculations as of 12/31/2018
Proponents of active management often counter that these numbers are misleading, and that they have the uncanny ability to identify, in advance, the good funds to buy and the bad funds to avoid for the future. Obviously, such a scenario would be extremely beneficial to investors everywhere. Unfortunately, the data doesn’t support their claim. S&P Dow Jones Indices conducts a semi-annual study to determine if there is any persistence in manager performance. In other words, should we expect those who have performed well in the past to continue performing well in the future? Unfortunately, the answer is no.
The study looked back at the top performing domestic stock funds from five years ago and then compared that group to the current top performers. Of the 571 top funds from March 2014 only 0.18% of them still maintained their status in March 2018. Statistically, it is more beneficial to blindly pick funds than focus on yesterday’s winners.
Active investors are quick to blame the environment (e.g. low interest rates, low dispersion of stock market returns, etc.) for their underperformance. We prefer to call attention to the more obvious culprit: the impact of fees. Morningstar’s study also looks at success rates based on expense ratios. Funds with higher expense ratios performed worse than their lower cost peers (see table below). The data helps solidify the view that fees should play an important role in the evaluation of all investment strategies, indexed or active. Even low-cost active funds still have a fairly low success rate, but the impact of fees is clearly significant.
10-Year Success Rates by Cost
| Category | Lowest Cost | Highest Cost |
| U.S. Large Blend | 17.3% | 2.1% |
| U.S. Mid-Blend | 21.9% | 12.5% |
| U.S. Small Blend | 41.0% | 25.6% |
| Foreign Large Blend | 31.6% | 13.2% |
Source: Morningstar Data and Calculations as of 12/31/2018
Active manager underperformance is not a new phenomenon, and seems to exist in all environments. Studies with data going back over 100 years show that active investment strategies have lagged more naïve, indexed approaches in virtually every market environment. Morningstar’s work confirms that the trend continues, and there is no indication it is likely change any time soon. The competitive nature of the capital markets and the high costs charged by active managers make it virtually impossible for them to outperform index funds. Any expectations to the contrary are what Vanguard founder Jack Bogle calls the triumph of hope over experience.
In addition to providing stronger performance potential for your participants, index funds also have the ability to offer protection to plan participants. By definition, they track the market, and cannot significantly underperform, which reduces the risk of employee complaints and lawsuits. Most index funds also tend to be very low cost, which is a hot button for the Department of Labor. Including index funds on your fund menu can therefore benefit the participants and the plan sponsor. Seems like a “no brainer”.