Debunking active management myths – Part 2

Debunking active management myths – Part 2 With $504 billion flowing into passively managed products and $316 billion fleeing actively managed mutual funds in 2016 in the U.S.1, the active-versus-passive debate appears to be tipping in favor of passive management. To be clear, at Russell Investments we believe active AND passive investing are credible strategies within a multi-asset portfolio. To help separate myth from truth in this debate, we have published a series of blog posts on the topic: Today, we tackle another Myth: Active management is broken; long-term performance proves it.

The basis for the myth

The Wall Street Journal recently published an article stating that “Indexes Beat Stock Pickers Even Over 15 Years.” The article concludes that “Even over a full market cycle, which includes peaks and troughs, we still see the majority of active managers performing unfavorably against their benchmarks.”2 This sentiment has reverberated throughout the industry for a while. After all, only 17% of the mutual funds included in the Morningstar U.S. Large Blend Category outperformed the Russell 1000® Index for the five years ending 2016.3 Large Cap U.S. Equity funds Source: Morningstar U.S. Large Blend Category. Russell 1000® Index. This has led many investors to interpret the struggles of large cap U.S. equity funds as a failure of active management in general. But let’s pause there. As a multi-asset provider that believes both active AND passive management can play a role, we are confident that skilled active managers can add value in every asset class, and we believe that active management success moves in cycles—which are at times difficult to predict. Before jumping to conclusions, we encourage a deeper analysis of the bigger picture.

A more balanced picture

  1. Other substantial parts of diversified portfolios have witnessed active management success

During the same five-year period ending December 2016 that saw Large cap U.S. equity mutual funds struggle:

  • 60% of emerging markets equity funds (Morningstar Diversified Emerging Markets Category) beat the MSCI Emerging Markets Index;
  • 64% of international equity mutual funds (Morningstar Foreign Large-Blend Category) beat the MSCI All-Country World ex-U.S. Index;
  • 80% of intermediate-term bond mutual funds (Morningstar U.S. Intermediate-Term Bond Category) beat the Bloomberg Barclays U.S. Aggregate Bond Index.

So clearly, the large cap U.S. equity experience has not been globally contagious.

  1. You’re not average, so look at the range of active returns to judge success. In our last blog in the series, we discussed that the average active manager is expected to underperform the market, net of fees. That’s why they are called average. While looking at the average active manager can be a good signal, an even better way to judge success is to look at the range of returns. For instance, based on Morningstar categories of actively-managed Large cap U.S. equity, Small cap U.S. equity, Emerging markets equity, International equity, Global equity and Intermediate-term bond mutual funds, at least 40% of funds outperformed in every category except Large cap U.S. equity, indicating there was a significant opportunity for skilled managers to outperform in the five-year period ending 2016. (see charts at the end of this blog post)
  1. Active fund returns move in cycles As the chart above illustrates, even within Large cap U.S. equity, there have been periods where active managers have had success beating the index, based on Morningstar categories of actively-managed mutual funds. For instance, in the aftermath of the tech bubble. In the five years ending 2003, more than 60% of funds in the Morningstar U.S. Large Blend Category outperformed, with the average fund outperforming by over 1%. There’s no reason to believe the same can’t happen again. In fact, we believe factors may be in place to help drive aggregate active manager performance again. We will address the cyclicality of active management in a future blog post in this series.
  1. When analyzing active management performance, consider using:
  • Five-year rolling time periods to temper end-point dependency and aligns with the length of a typical market cycle historically. For instance, the charts below use rolling five-year performance periods. Each data-point represents a five-year period. The last data-point on each chart represents the period from January 1, 2012–December 31, 2016.
  • Morningstar peer categories because they represent broad, rules-based universes of various asset classes with assigned benchmarks.
  • Net-of-fee excess returns. All mutual fund performance is reported net-of-fees relative to the Morningstar category benchmark. It is important to illustrate active fund performance after fees.
  • Interquartile range of returns (e.g., top, median, bottom quartiles) to achieve a clearer picture of whether the majority of funds have done well and express the magnitude of success/failure relative to a benchmark for top funds and bottom funds. This range of returns can also be more helpful than focusing on simply the average return, since an investor is unlikely to experience the precise average return.

These are the best practices we used in constructing the charts at the end of this post.

The bottom line

Most large cap U.S. equity mutual funds have faced performance challenges relative to the benchmark over the last five years ending 2016. This has caused many investors to question the value of active management. However, we caution against a wholesale indictment of active management based solely on a specific (albeit meaningful) asset class’ performance. We believe active management is cyclical and that truly skilled active managers can outperform. Impressive performance in emerging market equity, international developed and intermediate-term bond mutual funds over the past five years confirm this.

The following exhibits show historical active mutual fund returns in commonly used asset classes

Small cap U.S. equity funds Source: Morningstar U.S. Small Blend Category. Russell 2000® Index   Emerging Markets funds Morningstar Diversified Emerging Markets Category. MSCI Emerging Markets Index   International equity funds Source: Morningstar Foreign Large-Blend Category. MSCI All Country World ex-U.S. Index   Global equity funds Source: Morningstar World Stock Category. MSCI World Index.   Intermediate-Term bond funds Source: Morningstar U.S. Intermediate-Term Bond Category. Bloomberg Barclays U.S. Aggregate Bond Index
Disclosures: 1 Source: Morningstar. Passive products include long-term and sector mutual funds and ETFs. Excludes leveraged long/short products, money market funds and fund of funds. Active management includes all mutual funds, except money market funds and fund of funds. 2 Source: 3 Source: Morningstar. These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. This material is not an offer, solicitation or recommendation to purchase any security. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. Russell 1000® Index: Measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. MSCI All Country World ex-U.S. Index: The MSCI All Country World ex U.S. Index tracks global stock market performance that includes developed and emerging markets but excludes the U.S. Bloomberg Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index). Russell 2000® Index: Measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. MSCI World Index: The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand. The Russell logo is a trademark and service mark of Russell Investments. Copyright © Russell Investments Group, LLC 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty. Russell Investments Financial Services, LLC, member FINRA (, part of Russell Investments. RIFIS: 18827