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Rekenthaler Report

What Ails U.S. Stock-Fund Managers?

Their relative performance keeps declining.

The Cloud in the Silver Lining
Friday's column gave the silver lining for active U.S. stock fund managers. Over the trailing decade, the gross returns--before paying official fund expenses but after accounting for trading costs--of surviving large-company U.S. stock funds have been competitive with those of index funds. The problem for active funds has not primarily been with their investment decisions, but instead their high management fees and, to a lesser extent, to the taxes their strategies incur.

Unfortunately, if the past 20 years' trend continues, active funds will soon have that silver lining snatched away from them.

After reading Friday's column, Morningstar's Jeff Ptak--who would make an outstanding research assistant were he not my boss' boss (a pity, that)--took a closer look at active funds' gross returns. Jeff evaluated 20 years' worth of data, using rolling seven-year time periods. And, as I did, he compared the active category totals to an index of the relevant investment-style index.

Jeff then compiled and averaged those rolling seven-year periods into three groups: 1) Calculations with a starting date of Jan. 1, 2005, or later; 2) calculations with a starting date of Jan. 1, 2000, or later; and 3) calculations with a starting date of Jan. 1, 1995, or later. That is, he assembled the results over the past decade, those over the past 15 years, and those over the past 20 years.

As Jeff's rolling-year approach differed from mine, and his study ran through December 2014 while mine had an end date of November 2015, our numbers were never going to match. Happily, though, they told the same general story. Among the three large-company categories, active large-value managers had higher gross returns than the index in both studies. Active managements' gross returns for the other two categories hovered around those of the indexes.

By the Numbers

- Source: Morningstar

Now comes the interesting part. Contrast Jeff's 10-year figures for large-company stock funds with those for 15 and 20 years.

- Source: Morningstar

Ach, nicht so gut.

Active management's results for large-value funds have improved. But they've slumped for the other two categories of blue-chip U.S. stock funds. Over the longest time horizon, 20 years, the relative gross returns for active large-blend funds were nicely positive, and large-growth funds fared better yet. Indeed, at 1.37 percentage points per year, the outperformance by active large-growth funds was enough to make them fully competitive with index funds even after expenses.

The news is no better for mid- and small-company U.S. stock funds. Per Jeff's analysis, gross returns for the six mid- and small-cap categories stomped those of the comparison indexes for 20 years, with an average annual victory of more than 100 basis points for mid-cap funds, and 250 points for small-company funds. Now that's a thrashing! But the victory margin has shrunk over the more recent decade, such that only active small-value funds have been able to beat the indexes after paying expenses.

- Source: Morningstar

The downturn in active management's fortunes is even stronger than it first seems, because the 10-year group is contained within each of the the longer groups. That is, the 15- and 20-year figures would be even more favorable for active managers were they not pulled down by the lower 10-year totals.

Three Possibilities
To address this column's headline, what ails active management? (It's not survivorship bias, as Jeff included all funds that existed during each seven-year rolling period, even if the fund is no longer alive.) Three possibilities come to mind:

1) Benchmark Mismatches
Usually, when fund-versus-index comparisons are unstable over time, the main reason is that the index is not a perfect match for the fund's Morningstar Category.

One example would be with foreign-stock funds, which in the 1990s held much less in Japanese stock than did the benchmark MSCI EAFE Index. In addition, the active foreign-stock funds consistently own more emerging-markets securities. Most performance variations between the active funds and the indexes owe to these and other structural differences rather than to better or worse security selection by active management.

Large-company U.S. stock funds are another example, as most dabble in smaller fare and thus have a smaller-company tilt than either the S&P 500 or even the Wilshire 5000. This makes active large-company managers look smart when the broad market thrives and dumb when the bluest of chips lead the way. Of course, they are neither smart nor dumb in those situations--only different.

In this instance, though, benchmark mismatches are very likely a minor effect. I don't see how such a mismatch could cut across eight of the nine Morningstar Style Box categories (with only the large-value category being a modest exception to the pattern). The plunge of active management's fortunes seems too prevalent to chalk up to the type of category-by-category quirks that occur with benchmark mismatches.

2) Stiffer Competition
Perhaps current fund managers are better than those of 15 or 20 years ago. Perhaps the growth of index funds has squeezed out the weaker active fund managers. Back in the day, second-rate professional investors could wave their arms, tell their stories, and attract enough naive hopefuls to make a nice living. These days, everybody knows about indexing, and nearly all assets flow either into passive funds or into a handful of the top active funds.

In the words of Morningstar's Chris Davis, "That leaves the most skilled investors alone at the table. You'd think those remaining would be able to take advantage of this environment, but they're competing against other highly skilled investors trying to do the same thing. In baseball terms, it's a lot harder to hit .400 today than 50 years ago because the players are better."

Oh the irony! The sales success of index funds has led to … the better performance of index funds.

3) The 2000-02 Technology-Stock Crash
This explanation is the strongest of the bunch. As a whole, active mutual fund managers were a bit leery of the giant 1990s technology bull market. They were nowhere near as skeptical as with Japan the decade before; it's not as if their technology weightings were a mere fraction of the indexes'. But most did underweight technology, moderately, as the rally progressed.

This decision put most active U.S. stock funds in good stead when the bear arrived. (Regrettably to their shareholders, active U.S. stock funds could not repeat their relative success when the next crash occurred, in 2008.) As the 2000-02 period appears in Jeff's 15- and 20-year groups, but not in his 10-year totals, it's natural that the active managers look better over the longer periods.

Notably, the study's value categories bucked the general trend. The relative performance of active large-value managers has actually improved, rather than declined, over the most recent decade, and the slippage for the mid- and small-cap value categories has been modest. This supports the tech-stock theory, as neither value funds nor value indexes ever had much technology, suggesting that their results would be relatively unaffected by the events of 2000-02.

My take: There's something to the competition theory, but even more to the fact that active management couldn't repeat its relative success from 2000 to 2002 when the next stock-market crash hit in 2008. That failure continues to penalize its relative performance, as well as the perception of the marketplace. If active stock-fund management is to thrive, and to make a strong case for itself against indexing, it must outperform during the major bear markets. It must.

John Rekenthaler 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 typically agrees with the views of the Rekenthaler Report, his views are his own.