Active managers failed to deliver in a “once-in-a-decade” opportunity earlier this year in the latest piece of evidence that the majority of stock pickers do not outperform passives after fees.
According to recent research conducted by Morningstar, just half of active stock funds and one-third of active fixed income funds managed to outperform their passive equivalents during the first six months of 2020.
The value of stock selection dramatically increases when dispersion levels are high. Therefore, when extreme volatility hit the market in March a bigger gap between winners and losers was caused.
From 1 February until 4 March, rolling 21-day S&P 500 dispersion levels were hovering around 25%. From 4 March until 17 March, these levels climbed consistently to over 45%.
This pushes the odds in the favour of active managers who should be able to see more clearly the difference between the winners and losers.
However, this was simply not the case especially in fixed income where active managers took more credit risk relative to passives which drove the underperformance.
While there is evidently room both active and passive within a model portfolio, there are still too many active funds within the ecosystem that consistently underperform.
Steps have been taken by the UK regulator to crack down on 'closet trackers'. Last November, the Financial Conduct Authority (FCA) fined Janus Henderson £1.9m for charging up to 1.5% for two active funds that were deemed 'closet trackers' while it also implemented fines of £34m against a number of asset managers in 2018.
As Dimitar Boyadzhiev, senior analyst, manager research, passive strategies, said: “In theory, one often posited by active managers, the early-2020 volatility caused by the COVID-19 pandemic should have been a once-in-a-decade opportunity for them to deliver excess returns, shielding investors from a vicious drawdown in global markets.
“In practice, only about half of active stock funds and one-third of active fixed-income funds bested their average passive peers.”
One interesting development is the push from the ETF industry to launch active ETFs. While this makes sense in the US due to the tax benefits ETFs have across the pond, this is not the case in Europe, where calls have been just as strong.
By simply turning active mutual funds into ETFs, managers will not get away from the problem of underperformance.
Index funds were created in response to the problem of manager underperformance. The ETF industry is in danger of mutating into the exact issue they were created to address, and it is something it should look to avoid.