The first edition of Morningstar’s European Active/Passive Barometer1 shows the extent to which active managers in the region have underperformed their passive peers in recent years, suggesting the active-management industry must contend not only with high costs but with poor returns too.
According to the report on the performance of about 9,400 European-domiciled funds, or roughly a third of the region’s fund market, active managers that existed throughout the past ten years outperformed their passive counterparts in only two of 49 categories.
In two of the largest categories, Europe Large-Cap Blend and Global Large-Cap Blend, active investors fared particularly poorly. In the first case, only 16% of active managers beat their passive counterparts in the ten years through June 2018, while in the second case 11.5% did so. In the US Large-Cap Growth category, stockpickers fared even worse: less than 1% of those who were active in the past ten years recorded higher returns than the passive sector.
“The key finding from the study is that for most categories, passive funds appear as the obvious option for investors, with biggest odds of success,” said Dimitar Boyadzhiev, analyst at Morningstar covering passive strategies in Europe, in an interview.
The Morningtsar study compares active funds not against a cost-free index, but against a composite of index funds, in order to incorporate the latter group’s managing costs. Passive funds’ fees have fallen in recent years, with Fidelity Investments this year unveiling the first index funds that command zero management fees. Active funds have had to follow with fee reductions of their own.2
The study also assesses active funds based on their beginning-of-period category classification to better simulate the funds an investor would have had to choose from at the time.
The data sheds light on the efficiency of the two distinctive investment approaches that are nonetheless increasingly being used in combination. Following years of debate centered on the arguments in favor and against the two investment styles, more professional asset managers and asset allocators are combining passive and active funds to access markets and strategies efficiently.
Survivorship rates linked to success
In Europe Large-Cap Blend, the second-most popular equity category by number of active funds, 44% of the 645 active funds that existed ten years ago still traded by June this year, the Morningstar report showed. The survivorship rate for the passive group – 59 funds ten years ago – was 63%.
“Survivorship rates are positively correlated with odds for success,” the report, signed by Boyadzhiev, Ben Johnson and Adam McCullough, said. “The biggest driver of active funds’ failure is their inability to survive, which is often a result of lacklustre performance.”
To be sure, the active group’s performance gap in the Europe Large-Cap Blend cluster narrowed in recent years. From 16% that outperformed ten years ago, those with an edge increased to 20%, 23% and 28% of the total, respectively, in the 5-, 3- and 1-year periods.
Two outlying categories
In only two categories did investors selecting active managers over ten years do better than those who chose passive alternatives: UK Mid-Cap Equity and Norway Equity. In UK Mid-Cap Equity, three out of four active managers outperformed their passive peers over the period.
Specific idiosyncrasies can explain the stand-out returns of stockpickers in some markets, Boyadzhiev said. Among them are the depth of the market’s research coverage and the average capitalization of stocks.
Outperformance in the bonds market
The subpar results of active funds extended to the bonds market, an area where index funds have lagged behind in assets under management. In the segment’s most popular category, EUR Diversified Bonds, only 15% of active funds outperformed their passive peers in the past ten years. Just five index funds existed throughout the ten years in this category, compared with 325 active funds. In the past year, only 1.5% of active managers beat the passive group.
Since 2009, investors have poured a net $2.5 trillion in passive equity funds, compared to net outflows of $2 trillion from their active counterparts, according to data from Bank of America Merrill Lynch.3
1‘Morningstar’s European Active/Passive Barometer,’ October 2018.
2 Morningstar, ‘Fund Fees Drop 20% But Investors Still Flock to Passives,’ Oct. 23, 2018.
3 BofAML, ‘The Flow Show,’ Sep. 14, 2018.