Are fund managers worth their fees?

The tide may have turned for fixed-income fund managers, according to a new study from Morningstar Australia that compares the performance of active versus passive funds over trailing three, five and 10-year periods.

The Morningstar Australian Active/Passive Barometer is the first local version of the research, which has been conducted on a six-monthly basis in the US for more than 15 years. The latest iteration covers a universe of 118 passively managed strategies and 613 actively managed strategies across nine Morningstar Categories.

One of the big takeaways is that actively managed global bond fund returns, on aggregate, are back in positive territory. They outperformed passive funds across each period, turning in “less bad” figures of -3.2% and -0.1% across the three- and five-year timeframes – versus average returns of -5.1% and -0.3% in passive bond funds.

And over 10 years, 2.2% was the average return, versus 2.1% in the index funds.

Global bond funds

Morningstar research analyst Zunjar Sanzgiri, who crunched the numbers for the report, says they anticipated these results across the shorter timeframes because interest rates were declining for the bulk of this period, creating an environment that led most bond funds to underperform. But they were surprised at the turnaround over 10 years.

“Because of the reversal [in interest rate movements], active bond funds performance has compensated for the previous period of underperformance,” he says.

This reflects the ability of the portfolio managers of bond funds to actively buy shorter-dated bonds to offset the effects of rising interest rates.

“They’re not going to be as punished in a changing rate environment,” says Justin Walsh, associate director of Morningstar’s Asia Pacific manager research team.

Among passive bond funds, the average duration of the assets – the timeframe to maturity –was far lower. For example, Walsh points out that one exchange-traded fund in the study had a 20-year duration, leaving it highly vulnerable to interest rate movements.

Will the good time for bonds continue?

Like everything else in financial markets lately, it’s impossible to know – even with the dominant “higher for longer” view on interest rates (alongside yesterday’s rate rise and commentary from the RBA Governor Michele Bullock).

“A falling and stable interest rate environment has been a headwind for passive funds, but it doesn’t mean it’s going to remain that way,” Walsh says.

“The rising interest rate environment is challenging for passive funds. Over a long time, it should even out but the last couple of years have been very dramatic, and we’ve seen the effects of that.”

Fundies shine in small- and mid-caps

There were also encouraging signs for investors using managed funds to buy small- and mid-cap stocks, with active funds clearly outperforming passive within this cohort.

Australian funds in the blended category (combining Value and Growth investment strategies) of small- and mid-caps showed “clear and consistent dominance,” says Walsh and Sanzgiri. The active managers outperformed passive funds across each of the three-, five- and 10-year periods – and by a substantial margin.

“The lower end of the market-cap spectrum carries ample inefficiencies through which active managers can add value over the passive benchmarks.

Australian mid- and small-cap blend

What’s behind these numbers? Walsh and Sanzgiri explain this is partly a reflection of the lower efficiency of the index – primarily the ASX Small Ordinaries – tracked by small- and mid-cap focused passive funds.

The return figures above paint a positive picture for active funds, but the Morningstar team emphasise there were some big differences in performance.

“We’ve concluded that if you get it right, you could do very well, but if you don't pick an outperforming manager, you can do substantially worse than the passive composite,” Walsh says.

The study showed the passive fund returns were grouped quite closely – sometimes better, sometimes worse. But there were large dispersions between the best and the worst active small- and mid-cap fund returns.

For example, the worst fund delivered a -12.5% return over five years, while the worst topped 14%

What about large-cap funds?

The performance gap here still favoured the active funds but by a narrower margin. As the table below shows, the returns were just slightly better across three and 10 years. And over five years, the study showed the index funds beat the fund managers by 0.5%.

Australian large-cap blend

When the study became more granular, it threw up some unusual results. For example, in the Australian large-cap Value category, active managers clearly outperformed the passive funds. But Walsh and Sanzgiri believe this reflects our market’s lack of a standard, investable “value” index. For instance, Australia has no equivalent of the US Russell 1000 Value benchmark.

In Australia, passive funds in the value cohort are all dividend-focused, which limits the opportunity set because it screens out companies that don’t meet the yield criteria.

Emerging markets exposure

Walsh’s earlier point about the dispersion of returns across active managers was also clear in this space. In this case, the importance of fund manager selection is highlighted by the “success rate” of emerging market funds. Over three and five years, active managers outperformed passive. “But the success rate for active funds was below 50%, which is counterintuitive,” says Walsh and Sanzgiri. This means that investors randomly choosing a fund to invest in the space had only a 50% chance of beating the index.

This reinforces the importance of selecting a good fund. Only 17 of the 38 active funds focused on emerging markets that survived the full 10-year period beat the passive fund. But the “outsized returns” from a couple of them lifted the average, as reflected below.

Global Investing

The findings here highlighted the appeal of passive funds for many investors: “Most active managers struggle to make up for the difference in fees compared with the passive funds,” says Walsh and Sanzgiri.

And global equities are clearly dominated by the US, which represents around 70% of the MSCI World ex-Australia Index.

“The US equity market is highly efficient and liquid, which makes it an uphill task for active managers to consistently add value,”

The study found the top-performing active funds had higher allocations to the US, which emphasises the need for investors – whether in managed funds or index funds – to understand the country allocations in their portfolio.

The combination of passive funds’ low fees and ability to track the very strong US market set a high bar for active managers.

“If you've got a high fee fund and you've got a lower weight or an underweight to the US market, that's been a big hurdle,” Walsh says.

Conclusion

It’s not earth-shattering, but a clear takeaway from the study is this: Wherever there’s an information advantage, active funds will tend to beat passive. In these cases, the simple rules-based approaches of passive investments don’t always capture the investment opportunity.

Active managers can exploit “informational deficiencies” that occur, explains Walsh.

 “And that happens in credit, it happens in the small-caps and in some very specialised fixed income areas – active managers can perform."

You’ve probably heard it before, but here it is again: “The benefit of passive is to have highly diversified portfolios,” Walsh says.

Global equities are one example, as is Australian style-agnostic investing (spanning growth and value) where “having a passive approach has been quite a successful strategy overall".

But where those rules-based advantages don’t exist, Walsh says it is “rich pickings” for active managers who can do it well.