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The Numbers Are In: Actively Managed Mutual Funds Are a Dodo Waiting for Extinction

By Alex Dumortier, CFA - Apr 5, 2016 at 11:53AM

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The first quarter was an unmitigated disaster for active fund managers, and the long-term performance numbers tell the same story.

All the king's horses and all the king's men couldn't put the active fund management industry back together again.

U.S. stocks are lower in early afternoon trading on Tuesday, with the S&P 500 (^GSPC -1.17%) and the Dow Jones Industrial Average (^DJI -0.39%) (DJINDICES: $INDU) down 0.86% and 0.56%, respectively, at 11:50 a.m. ET.

Despite a bit of excitement on the way, the stock market ended the first quarter in the black, with the S&P 500 gaining 1.5% (before dividends) -- not an awful result. However, it was an unmitigated disaster for U.S. equity fund managers. The numbers compiled by broker-dealer Bank of America Merrill Lynch, part of Bank of America, tell an ugly tale.

Fewer than one in five (19%) U.S. large-cap mutual funds beat the benchmark S&P 500 index, the lowest rate in a series that goes back to 1998. The average margin of underperformance -- 1.9 percentage points -- also set a new low.

Growth fund managers fared even worse, with just 6% of growth funds beating their benchmark -- the worst such result since at least 1991. The average margin of underperformance reached a whopping 3.5 percentage points.

Value fund managers essentially matched the performance of their large-cap peers, with a "beat rate" of 19.6.

Given the short length of the measurement period -- in investing, one quarter isn't really significant -- these numbers aren't a definitive indictment of the active fund management industry. ("Active" management aims to beat a benchmark index, while "passive" management aims only to track an index.)

However, this latest data adds to an already significant literature demonstrating that the current operating model of active fund management is broken: The industry is failing to deliver value to its customers.

Last month, I highlighted a large-scale study (PDF document will download) from S&P Dow Jones Indices, according to which fewer than one in five (17.9%) actively managed large-cap U.S. equity funds in the U.S. managed to beat the S&P 500 over the 10-year period through 2015. With regard to small-cap funds, the beat rate was little above 1 in 10 (11.6%)!

This is not an academic debate: Your ability to retire and the lifestyle you can maintain in retirement is partially dependent on the returns you earn on your retirement assets. Investors have not remained blind to this growing mountain of evidence: The flow of assets out of actively managed funds into index funds is turning into a tsunami that will ultimately require a wholesale reconstruction of the investment management industry based on a sturdier model.

Does this mean one should avoid selecting actively managed funds? That's not a bad rule. If you want to try your hand at it, I would recommend looking for funds that boast the following characteristics to maximize your odds of success:

  • Below-average portfolio turnover
  • Below-average management fees
  • Above-average fund manager tenure
  • Above-average active share
  • Fund managers and investment staff investing in their own funds ("eating their own cooking")

Finally, if the fund management house conducts its business in a manner that is markedly differently than its peers, that may be a sign that it's sufficiently bold and imaginative to invest differently, also (which is a requirement if one is to outperform the herd).

Take U.K. fund manager Woodford Investment Management, for example, which just announced that investment research costs would from April 1 be paid for by Woodford rather than out of fund assets (with no increase to the annual management fee). Furthermore, Woodford has pledged to disclose all transaction costs monthly on its website. That's the sort of fund manager you want working for you.

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