Active funds' outperformance linked to lower expense ratios

Research by American Funds finds that mutual funds with low expenses and higher manager ownership typically outperform. The comprehensive study of Morningstar’s database found that the gap between active and passive clearly narrows over a period of 20 years. Overall, active funds beat the index 35% of the time, however, when the universe is narrowed to funds with low fees and high manager ownership active funds beat the index 55% of the time. 

As the decade-long trend continues of investors pulling money out of actively managed funds in favor of cheaper indexed strategies, American Funds is coming forward with a not-so-subtle reminder that active management still has a place in most investment portfolios.

Through a research project dubbed Active Scorecard, the largest actively managed fund complex with $1.4 trillion under management shows that two key elements can help identify actively managed funds that are more likely to beat their benchmarks.

In a nutshell, it comes down to lower fund expenses and higher portfolio manager ownership of the fund.

The study, over multiple time periods, of the entire Morningstar Inc. fund database found that screening for low fund expenses and higher manager ownership helps to identify funds with better average returns than the average of all active funds and their respective indexes.

Key to the research is really long time periods.

For example, last year large-cap equity funds averaged a decline of 32 basis points, while the S&P 500 Index gained 1.41%. But, viewing it as American Funds did, on 1-year rolling periods over each month of the past 20 years through 2015, large-cap equity funds averaged an 8.7% gain, while the S&P averaged 9.8%.

The gap between active and passive clearly narrows when the performance is spread out over 20 years and averaged over 240 individual time periods, but active funds overall still only beat the index 35% of the time, according to American Funds’ research.

However, when only those funds with low fees and high manager ownership are included, the average return jumps to 10.1%, with those funds beating the index 55% of the time.

LOW FEES

American Funds, which are known for low fees, averaged a 10.7% return, beating the index 56% of the time.

When the analysis is expanded to 3-, 5-, and 10-year monthly rolling periods the case becomes even stronger for funds with low fees and high manager ownership, but it gets worse for active funds in general.

On the 3-year monthly rolling basis, over the same 20-year period, the average active large-cap equity fund returned 6.6%, the index returned 7.4%, and the select funds returned 8.1%, beating the index 64% of the time.

On a 5-year monthly rolling basis, average large-cap fund beat the index just 27% of the time, while the select funds beat the index 77% of the time.

And on a 10-year monthly rolling basis, average large-cap funds beat the index just 24% of the time, while select active funds beat the index 95% of the time, and American Funds, with a 6.7% return, beat the index 100% of the time.

“I’m not surprised American Funds is promoting active management, because that’s who they are, but the data is also consistent with what we’ve found about it being hard for active funds to outperform an index, which is basically free,” said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ.

SKIN IN THE GAME

The average large-cap equity fund has an expense ratio of 1.1%, which can go a long way toward making up the difference between the performance of an index and the average active fund. This is at least half of what American Funds is suggesting, according to Mr. Rosenbluth.

“If you don’t pick the average expense ratio, you can gain some basis points of performance,” he said.

This detail is generally not lost of the mutual fund industry, which has been ever-so gradually cutting fees. According to the Investment Company Institute, expense ratios for equity, bond and hybrid funds fell to their lowest level in two decades.

But the two-basis point average decline last year to a 68-basis point average, is still just window dressing, according to Mr. Rosenbluth.

“I think we should be seeing more pressure on expense ratios than we have seen,” he said. “More than half of the money in active funds is in the 10% of funds with the lowest expense ratios. That should cause all active funds to try and bring cost down to gather assets, but that’s not happening.”

In some cases, including The Vanguard Group, fees are actually inching higher.

On the issue of portfolio manager ownership, reporting of which the Securities and Exchange Commission has required since 2004, American Funds sees it is as a no-brainer.

“Portfolio manager ownership goes to stewardship and having interests aligned with investors,” said Steve Deschenes, senior vice president in client analytics and research at American Funds.

“Having some skin in the game is an indirect signal of good stewardship.”