Active vs. Passive: Our Take

In light of the ongoing controversy between active and passive equity investing, we decided to conduct an experiment comparing the two methods.  It seemed to us that advocates of passive investing tend to use calendar year returns to claim that active managers, as a whole, cannot beat the indexes, and therefore, portfolios should only be constructed with passive funds (i.e. index funds).  We chose to take the comparison a step further and compare trailing returns over longer time frames (3, 5, and 10 years) and also to compare risk-adjusted returns.  We wished to see if, in fact, active management did not measure up using these criteria, as well.

We also wanted to learn if active management performs better with less efficient asset classes, such as international and small cap, and if active management is more likely to outperform in bear markets.

Using Morningstar Advisor, we assembled a universe of funds in each of the categories used by HFA.  The table below shows the number of active (i.e. non-index) funds in each category that have been in existence for at least each of the time periods shown (ending 4/15/14).  Only one share class of a fund was used (generally this was the share class in existence the longest).

Total # of Active Funds
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Category,3 Year,5 Year,10 Year
U.S. Large Value,212,203,161
U.S. Large Blend,239,219,171
U.S. Large Growth,355,337,274
U.S. Small Cap,116,110,81
International-Developed Markets,97,91,62
International-Emerging Markets,45,35,19

Note that for Small Cap, the Morningstar category and style used is Small Blend/Small Blend, for International-Developed Markets the Morningstar category and style used is Foreign Large Blend/Large Blend, and for International-Emerging Markets the Morningstar category and style used is Diversified Emerging Markets/Large Blend.  This was done to match the investment style of the index fund used for comparison.

We then assigned an index fund to each of the categories. These are what would be used in an all-passive portfolio for each of the categories and represent the “hurdle” performance against which the active funds would be compared.  The assignments are as follows:

[table width=”600px”]
U.S. Large Value,iShares Russell 10000 Value ETF (IWD)
U.S. Large Blend,Vanguard 500 Index Adm. (VFAIX)
U.S. Large Growth,iShares Russell 1000 Growth ETF (IWF)
U.S. Small Cap,iShares Russell 2000 ETF (IWM)
International-Developed Markets,iShares MSCI EAFE ETF (EFA)
International-Emerging Markets,iShares MSCI Emerging Markets ETF (EEM)

The active funds in each category were then compared to the respective index fund for trailing annualized total return as well as two measures of risk-adjusted return:  Sharpe ratio (which measures return over a risk-free rate per unit of risk as measured by standard deviation) and Sortino ratio (a modification of the Sharpe ratio, which uses the standard deviation of negative returns only).  The results are given in the following tables:

# of Active Funds That Beat Index Fund
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Category,3 Year,5 Year,10 Year
U.S. Large Value,34,17,61
U.S. Large Blend,38,15,49
U.S. Large Growth,36,19,90
U.S. Small Cap,52,46,49
International-Developed Markets,25,29,33
International-Emerging Markets,21,19,7

% of Active Funds That Beat Index Fund
[table width=”600px”]
Category,3 Year,5 Year,10 Year
U.S. Large Value,16.0%,8.4%,37.9%
U.S. Large Blend,15.9%,6.8%,28.7%
U.S. Large Growth,10.1%,5.7%,32.8%
U.S. Small Cap,44.8%,41.8%,60.5%
International-Developed Markets,25.8%,31.9%,53.2%
International-Emerging Markets,46.7%,54.3%,36.8%

It should be noted that mutual fund returns are given net of fees and assume reinvestment of all income and capital gain distributions.  Past performance cannot guarantee future results.

At first glance, and especially for large cap U.S. equities (which are the most efficient asset class), it does appear that the results bear out the contention that few active managers can beat their benchmarks.  However, this is considerably less so in the less efficient asset classes-small cap and international.  Also worth noting is the fact that for the 3-and 5-year returns (bull market), the active funds as a whole did not do as well as they did for the 10-year returns, which include both the bull market from March 2009-present as well as the bear market from late 2007-early 2009.  This seems to indicate that active management has a better chance of outperformance in a falling market as, at least in theory, active managers have the flexibility to take a more defensive posture while index funds must remain fully invested.

A question worth asking, too, is what do we conclude from the fact that the “average” active fund does not beat the benchmark?  It seems to us that this contention is only valid if active mutual funds are picked completely at random (by drawing names from a hat, for example) as opposed to making the selection after thorough analysis and due diligence, as should be done.  Of course, past performance cannot guarantee future results, but it would seem that the likelihood of choosing an active fund that outperforms its benchmark would be greatly increased this way.

In conclusion, we feel that both active and passive investments have a place in a portfolio and can be seen as yet another way to diversify.  Furthermore, passive investments by their nature are generally more tax efficient and are better suited for use in taxable accounts. If you have any questions on this topic, please feel free to contact our office and we would be happy to answer them.