Oct 5, 2024 | 16 min read
Executive Summary
Passive investing has been steadily gaining ground on active management, culminating in a historic shift in 2023 when passive funds surpassed active funds in assets under management for the first time. This blog post delves into the reasons behind this trend, examining the performance of various actively managed mutual funds against their benchmarks and highlighting the challenges and potential pitfalls of active management.
Our analysis reveals that most actively managed funds underperform their benchmarks over time, often due to higher fees and the difficulty of consistently making correct investment decisions. While some active funds do outperform, they are the exception rather than the rule. For most investors, a core portfolio of low-cost index funds, potentially supplemented with carefully selected active funds, may offer the best balance of performance, risk, and cost.
Introduction
In the world of investing, few debates are as enduring as that between active and passive investment strategies. Active investing involves portfolio managers actively selecting and trading securities in an attempt to outperform a specific benchmark or market index. Passive investing, on the other hand, aims to mirror the performance of a market index by holding all (or a representative sample) of the securities in that index.
The growing appeal of passive investing is evident in its remarkable growth trajectory. A watershed moment arrived in 2023 when, according to Morningstar, the most widely cited group tracking the fund management sector, passive funds surpassed actively managed funds in assets under management for the first time.
Historical Active vs Passive Flows by Category Group
Source: Morningstar. Data as of Dec. 31, 2023.
Despite the growing dominance of passive investing, the debate surrounding its efficacy compared to active management remains relevant. This case study examines the performance of several prominent actively managed mutual funds against their primary benchmarks. A fund benchmark is a standard against which performance of a mutual fund is measured. It is usually an index that represents a particular segment of the market. We'll focus on three passively managed funds that represent three major indices:
SPY tracks the S&P 500 index, representing the broad U.S. stock market.
IWF tracks the Russell 1000 Growth index, focusing on large-cap growth stocks.
IWD tracks the Russell 1000 Value index, concentrating on large-cap value stocks.
These passive funds differ in their investment styles and sector exposures.
SPY offers a blend of growth and value stocks with broad sector exposure. IWF is growth-oriented and more concentrated in sectors like technology. While IWD is value-oriented with higher exposure to sectors like financials and healthcare.
Our thesis: Despite the best efforts of skilled fund managers, passive investing often outperforms active management over the long term. We will examine a range of fund characteristics to understand why index funds like SPY almost always come out ahead and how challenging it is to consistently beat the market.
Overview of the Mutual Funds
We've selected a diverse group of actively managed mutual funds for this study, as shown in the following table:
Source: Morningstar. Data as of Jul. 31, 2024.
These funds represent a cross-section of well-established equity funds managed by reputable financial institutions. They include large growth, large blend, and large value categories, allowing for comparison against different market segments.
Our selection criteria for these funds were as follows:
Actively managed equity mutual funds (>98% invested in equities)
Well-established with a long track record (>20 years)
High portfolio turnover (>10%)
Large funds (>$10B in managed assets)
Primarily comprised of large stocks (>$5B in market capitalization)
Benchmarks against a major market index like S&P 500 or Russell 1000 Index
Managed by reputable financial institutions like Capital Group and T. Rowe Price
This diverse selection provides a robust dataset for our analysis, allowing us to examine how active management fares against passive indexing across various market cycles and economic conditions.
Fund Characteristics
Assets Under Management
Source: Morningstar. Data as of Jul. 31, 2024.
The chart above illustrates the assets under management (AUM) for each fund in our study. We can observe significant variations in AUM across the funds. SPY stands out with the largest AUM, which is not surprising given its role as a core holding for many investors and institutions. Among the actively managed funds, we see a range of sizes, with some like AGTHX and AWSHX managing substantial assets, while others like FMAGX have comparatively smaller AUMs.
This substantial difference in fund size raises important considerations about scalability and flexibility in investment strategies. The size of a fund can have implications for its performance and risk profile. Larger funds may benefit from economies of scale but might also face challenges in maintaining agility in their investment strategies. Smaller funds might have more flexibility but could be more vulnerable to large inflows or outflows.
Geographic Diversification
Understanding a fund's geographic exposure provides crucial insight into its investment strategy and potential risk-return profile. The chart below illustrates the percentage of each fund's assets invested in U.S. and non-U.S. equities.
Source: Morningstar. Data as of Jul. 31, 2024.
We can see that all funds in our study maintain a strong focus on U.S. equities, with most allocating over 90% of their assets domestically. The passive index funds (SPY, IWF, IWD) are almost entirely invested in U.S. equities, as expected given their mandates. Among the actively managed funds, we observe some variation in international exposure. Funds like DODGX and ANCFX have notably higher allocations to non-U.S. equities, potentially offering more geographic diversification.
These allocation differences can significantly impact fund performance and risk profiles. Funds with higher international exposure may offer greater diversification benefits but could be more susceptible to currency fluctuations and geopolitical risks. Conversely, U.S.-focused funds might benefit from the historical strength of the U.S. market but could miss opportunities in emerging markets.
Portfolio Concentration
An important aspect of fund analysis is understanding how concentrated a fund's holdings are, particularly in its top positions. The chart illustrates the percentage of assets allocated to the top 10 holdings for each fund in our study, along with their total count of holdings.
Source: Morningstar. Data as of Jul. 31, 2024.
The passive index funds (SPY, IWF, IWD) show lower concentration levels, reflecting their broad market exposure. Among the actively managed funds, we see varying degrees of concentration. Funds like FCNTX and AGTHX have higher concentrations in their top 10 holdings, suggesting a more focused investment strategy. Others, like DODGX and VWNDX, show lower concentration levels, indicating a more diversified approach.
Higher concentration can potentially lead to higher returns but also increases risk if those top holdings under perform. Lower concentration may offer more stability but could limit the fund's ability to significantly outperform the market.
Sector Exposure
Understanding a fund's sector allocation provides crucial insight into its investment strategy and potential risk-return profile. The chart illustrates the sector breakdown for each fund in our study, focusing on four main sectors: Technology & Telecom, Financial Services, Healthcare, and Other sectors.
Source: Morningstar. Data as of Jul. 31, 2024.
SPY shows a balanced distribution across sectors, representing the broad market. IWF has a notably higher allocation to technology and consumer discretionary sectors, reflecting its growth focus. IWD shows higher allocations to financial and healthcare sectors, typical of value-oriented strategies.
Among the actively managed funds, we see various sector allocation strategies. Some funds, like AGTHX and FCNTX, show sector distributions similar to the Russell 1000 Growth Index, indicating a growth-oriented approach. Others, like DODGX and VWNDX, have sector allocations more aligned with value strategies.
These sector exposures can significantly impact fund performance, especially during periods when certain sectors outperform or underperform the broader market.
Portfolio Turnover
The turnover ratio measures the rate at which a fund's assets are bought and sold over a year, providing insight into the fund's trading activity and potential tax implications. SPY, as a passive index fund, has a very low turnover ratio of 2%. In contrast, the active funds in our study show a wide range of turnover ratios. This figure is typically between 0% and 100% but can be even higher for actively managed funds. A turnover rate of 0% indicates the fund's holdings have not changed at all in the previous year.
Source: Morningstar. Data as of Jul. 31, 2024.
The passive index funds (SPY, IWF, IWD) have the lowest turnover rates, as expected. They aim to track their respective indices and thus require minimal trading.
Among the actively managed funds, we see a wide range of turnover rates. Funds like FMAGX and AGTHX have notably high turnover rates, suggesting very active management styles. Others, like DODGX and VWNDX, have lower turnover rates, indicating a more patient, "buy-and-hold" approach.
Higher turnover can lead to increased transaction costs and potentially higher tax liabilities for investors in taxable accounts. However, it may also allow managers to capitalize on short-term market opportunities. Lower turnover typically results in lower costs but may limit a fund's ability to react quickly to market changes.
Fees
The expense ratio represents the annual cost to investors for managing the fund, expressed as a percentage of AUM. The chart below reveals significant differences in fees across our selected funds.
Source: Morningstar. Data as of Jul. 31, 2024.
As expected, the passive index funds (SPY, IWF, IWD) have the lowest expense ratios, typically below 0.20%. This cost efficiency is a key advantage of passive investing.
Fees for actively managed funds that benchmark S&P 500 Index range 0.47%-0.63%, a ~4x-7x cost difference over SPY. Fees for funds that benchmark IWF and IWD range 0.39%-0.91%, a ~2x-5x cost difference over those benchmark funds.
Higher fees significantly erode long-term returns, as they represent a consistent drag on performance. Even small differences in expense ratios can compound over time to substantial amounts. Active managers need to outperform not only the benchmark index, but the index plus their higher fees to deliver superior returns.
Performance Comparison
Total Excess Return
The following table presents the total excess return (or under performance) of each fund compared to its benchmark over various time periods. A positive number indicates out performance, while a negative number represents under performance.
Source: Morningstar. Data as of Jul. 31, 2024.
Key observations:
During the 20-year period, only a few funds (AGTHX, ANCFX, FCNTX, VWNDX) managed to outperform their benchmarks, albeit over different time periods.
The majority of actively managed funds under performed their benchmarks across all time periods.
The degree of under performance tends to increase over longer time horizons for most funds.
VWNDX stands out with consistent out performance across all time periods.
These results highlight the challenge active managers face in consistently outperforming their benchmarks over long periods, supporting our thesis that passive investing often beats active management in the long run.
Annualized Excess Return
Source: Morningstar. Data as of Jul. 31, 2024.
This table shows the annualized excess return (or under performance) of each fund compared to its benchmark. Annualizing the returns allows for a more standardized comparison across different time periods.
Key observations:
The annualized figures generally show smaller differences than the total excess returns, but the overall trend remains similar.
Most actively managed funds show negative annualized excess returns, indicating under performance.
VWNDX consistently shows positive annualized excess returns across all periods.
Even funds that outperformed over 20 years (like AGTHX and ANCFX) show periods of under performance in shorter time frames.
These annualized figures reinforce the difficulty of consistently outperforming market benchmarks through active management, especially over longer time horizons.
Performance vs. S&P 500 Index (SPY)
Source: Yahoo Finance. Data as of Jul. 31, 2024.
This graph illustrates the 20-year performance of funds bench-marked against the S&P 500 (SPY). The lines represent the cumulative returns of each fund relative to SPY.
Key observations:
Most funds show periods of both out performance and under performance relative to SPY.
There's significant variation in performance among actively managed funds.
Some funds, like AGTHX and ANCFX, have managed to outperform SPY over the full period, but with considerable volatility.
Other funds, like AWSHX and AMRMX, have consistently under performed SPY.
This graph highlights the variability in active fund performance and the challenge of consistently beating a broad market index like the S&P 500.
Performance vs. Russell 1000 Growth (IWF)
Source: Yahoo Finance. Data as of Jul. 31, 2024.
This graph illustrates the 20-year performance of funds bench marked against the Russell 1000 Growth Index (IWF). The lines represent the cumulative returns of each fund relative to IWF.
Key observations:
FCNTX has consistently outperformed IWF over the 20-year period, demonstrating strong performance in the growth category.
TRBCX and PRGFX have generally tracked close to IWF, with periods of slight out performance and under performance.
TWCUX has consistently under performed IWF, suggesting challenges in keeping up with the growth index.
The performance gap between the best and worst-performing funds widened significantly over time.
This graph highlights that even among growth-oriented funds, there can be substantial performance differences over the long term.
Performance vs. Russell 1000 Value (IWD)
Source: Yahoo Finance. Data as of Jul. 31, 2024.
This graph shows the 20-year performance of funds bench marked against the Russell 1000 Value Index (IWD). The lines represent the cumulative returns of each fund relative to IWD.
Key observations:
VWNDX has consistently and significantly outperformed IWD over the 20-year period, standing out as a strong performer in the value category.
PRFDX has generally tracked close to IWD, with slight under performance in recent years.
The performance gap between VWNDX and PRFDX has widened over time, illustrating the potential for significant divergence even among funds with similar investment styles.
This graph demonstrates that active management can potentially add value in the value investing space, but success is not uniform across all funds.
Risk & Volatility Analysis
Alpha
Alpha measures the difference between an investment's expected returns based on its beta and its actual returns. A positive alpha indicates the investment has performed better than its beta would predict. A negative alpha indicates an investment has under performed, given the investment's beta.
Source: Morningstar. Data as of Jul. 31, 2024.
Key observations:
Most funds show negative alpha across various time periods, indicating difficulty in consistently outperforming their benchmarks on a risk-adjusted basis.
FCNTX and VWNDX stand out with positive alpha over multiple periods, suggesting these funds have added value above their benchmarks.
Alpha tends to decrease over longer time periods for most funds, highlighting the challenge of maintaining out performance over extended periods.
These results underscore the difficulty active managers face in consistently generating alpha, supporting the case for passive investing.
Beta
Beta measures an investment's sensitivity to market movements. A beta greater than one indicates the investment is more volatile than the market. If beta is less than one, the investment is less risky than the market.
Source: Morningstar. Data as of Jul. 31, 2024.
Key observations:
Most funds have a beta close to 1, indicating similar volatility to their benchmarks.
Growth-oriented funds (e.g., FCNTX, TRBCX) tend to have slightly higher betas, suggesting higher volatility.
Value-oriented funds (e.g., DODGX, VWNDX) generally have lower betas, indicating lower volatility.
The passive index funds (SPY, IWF, IWD) have betas very close to 1, as expected.
These beta values suggest that most active funds in our study don't significantly deviate from their benchmark's volatility, though there are slight variations based on investment style.
Sharpe Ratio
Sharpe Ratio indicates the reward per unit of risk by using standard deviation and excess return. The higher the Sharpe ratio, the better the investment's historical risk-adjusted performance.
Source: Morningstar. Data as of Jul. 31, 2024.
Key observations:
The passive index funds (SPY, IWF, IWD) show competitive Sharpe ratios, particularly over longer time periods.
Among active funds, FCNTX and VWNDX consistently demonstrate higher Sharpe ratios, aligning with their strong performance noted earlier.
Many active funds show lower Sharpe ratios than their benchmarks, especially over longer periods, indicating challenges in providing superior risk-adjusted returns.
Sharpe ratios tend to converge over longer time periods, suggesting that maintaining superior risk-adjusted performance becomes more difficult over time.
These Sharpe ratio comparisons provide further evidence that passive investing often provides competitive risk-adjusted returns compared to active management, especially over extended periods.
Standard Deviation
Standard Deviation measures the range of an investment's performance. The greater the standard deviation, the greater the investment's volatility.
Source: Morningstar. Data as of Jul. 31, 2024.
Key observations:
The passive index funds (SPY, IWF, IWD) show consistent standard deviations across different time periods, with IWF (growth) having higher volatility than IWD (value).
Among active funds bench marked to the S&P 500, most show similar or slightly higher standard deviations compared to SPY.
Growth-oriented funds (e.g., FCNTX, TRBCX) generally exhibit higher standard deviations, aligning with their higher-risk strategies.
Value-oriented funds (e.g., DODGX, VWNDX) tend to have lower standard deviations, consistent with their typically more conservative approach.
These results suggest that active management doesn't necessarily lead to lower volatility, and in many cases, may actually increase it.
Challenges of Active Management
In summary, the data highlights several challenges faced by active managers:
Consistent out performance is rare With only one fund (VWNDX) beating its benchmark over 20 years. This underscores the difficulty of consistently making correct investment decisions over long periods.
Higher significantly erode returns over time Active managers need to outperform not just the index, but the index plus their higher fees to deliver superior net returns to investors.
Larger fund sizes limit flexibility and potential for out performance As funds grow, it becomes increasingly difficult to find enough attractive investments to meaningfully impact returns.
Frequent manager turnover & strategy shifts can lead to inconsistent performance Unlike passive funds, active funds may change their approach or leadership, potentially disrupting long-term performance.
Higher portfolio turnover in active funds can lead to more frequent capital gains distributions and higher tax burdens
Fund managers are susceptible to cognitive behavioral biases that can negatively impact decision-making
Pressure to perform in the short term can lead to sub optimal long-term decisions
Sector allocation decisions can significantly impact performance. Active managers must correctly predict which sectors will outperform, adding another layer of complexity to their decision-making process.
Managing international exposure adds another layer of complexity, requiring managers to navigate diverse economic conditions and currency fluctuations.
Benefits of Passive Investing
The case for passive investing is strong:
Lower fees preserve more of the investor's returns Over long periods, this fee advantage can lead to significantly better outcomes for investors.
Broad market exposure provides built-in diversification Index funds like SPY offer exposure to a wide range of companies across various sectors, reducing company-specific risk.
Consistent strategy is easy to understand and implement Investors always know what they're getting with an index fund, without worrying about style drift or manager changes. They are transparent in their holdings and methodology.
A Tale of Two Funds
Out performer: Windsor (VWNDX)
VWNDX's consistent out performance across various time periods demonstrates that skilled value managers can beat the market. Its focus on undervalued companies with strong fundamentals has served it well, particularly in challenging market conditions.
However, its slightly higher volatility (standard deviation of 20.00 over 5 years compared to IWD's 18.40) suggests that this out performance comes with some additional risk. Investors in VWNDX need to be comfortable with this marginally higher volatility and have the discipline to stay invested during market downturns.
Its moderate concentration (16% in top 10 holdings) likely contributed to out performance while maintaining a reasonable level of diversification. The fund's relatively low international exposure (15% of assets) may have contributed to its strong performance during periods of U.S. market out performance.
VWNDX's success raises questions about repeat-ability. Can it continue to outperform in different market conditions, particularly if value investing falls out of favor? Will potential manager changes impact its strategy and performance?
The fund's balanced sector allocation, with 21% in Financials and 17% in Healthcare, likely contributed to its strong and consistent performance, providing stability across various market cycles.
Under performer: Stock Fund (AMRMX)
With consistently negative excess returns and a relatively high expense ratio (0.57%), AMRMX illustrates the potential pitfalls of active management. The fund has struggled to maintain its edge in recent years. AMRMX's under performance highlights the challenges of maintaining superior returns over extended periods. Changes in fund management and shifts in market conditions can significantly impact long-term performance.
Despite moderate concentration (29% in top 10 holdings), it under performed, highlighting that concentration alone doesn't guarantee success. Its low international allocation (9% of assets) hasn't helped mitigate its under performance relative to the U.S.-focused SPY.
This case also demonstrates how fees can exacerbate under performance. AMRMX's above-average expense ratio further reduced already low returns, compounding the negative impact on investor wealth over time.
Despite a relatively balanced sector allocation, with 25% in Tech & Telecom and 16% in Financials, AMRMX has struggled to translate this into competitive performance. This suggests potential issues with stock selection or timing within these sectors.
The fund's higher volatility (standard deviation of 18.00 over 5 years compared to SPY's 17.00) indicates that investors are taking on additional risk without commensurate returns, further highlighting the challenges faced by this active strategy.
Conclusion
This 20-year comparison provides compelling evidence for the advantages of passive investing. While some active funds demonstrated periods of out performance, the more consistent and lower cost approach of passive index funds proved difficult to beat over the long term.
Key findings include:
Most actively managed funds in our study under performed their benchmarks over various time periods.
Passive index funds demonstrated competitive risk-adjusted returns (Sharpe ratios) compared to active funds.
Fund size and turnover can impact performance, with very large funds potentially struggling to outperform due to reduced flexibility.
Active funds generally had higher fees and, in many cases, higher volatility than their passive counterparts.
While some active funds (e.g., VWNDX) managed to outperform consistently, they were the exception rather than the rule.
These results highlight the challenges active managers face in consistently generating alpha and justifying their higher fees. While skilled active management can add value, identifying such managers in advance is difficult.
For most investors, a core passive strategy using low-cost index funds like SPY, IWF, or IWD may provide a more reliable path to achieving market returns. However, there may still be a place for carefully selected active funds for those seeking the potential for out performance and willing to accept the associated risks and costs.
Your Investment Call to Action
As you review your investment portfolio, consider the following:
(If not already) Consider incorporating low-cost index funds like SPY for core portfolio holdings. These provide broad market exposure market exposure at minimal cost.
Why? Because the fees and turnover ratios of funds deeply impact their long-term results. Even small differences in expense ratios can significantly affect your wealth over time.
If choosing active funds, look for those with a consistent strategy, reasonable fees, lower turnover and a strong track record of risk-adjusted performance. Be prepared for periods of under performance, as even the best active funds rarely outperform consistently.
Reflect on your risk tolerance and investment goals. The right balance of active and passive strategies needs to align with your personal financial objectives and comfort with market volatility.
If you’re a DIY investor, build a practice to regularly review and re-balance your portfolio (perhaps annually or semi-annually) to ensure it stays in alignment with your long-term objectives.
If you seek professional advice, consider consulting with a fee-only financial advisor for personalized guidance on your investment strategy.
Remember: your investment choices should align with your personal financial goals and risk tolerance. While this study provides valuable insights, it's wise to consult with a financial advisor for personalized guidance.
For the majority of investors, a core portfolio of low-cost index funds like SPY, potentially supplemented with carefully selected active funds, offers the best balance of performance, risk, and cost. This approach allows investors to capture market returns reliably while still leaving room for potential out performance through active management.
Investing is a long-term journey, not a destination. It’s best done by staying informed, remaining disciplined, and zooming out to the long-term picture.
Whether you choose active funds, passive index funds, a combination of both, the key is staying the course through the market highs and lows with a well-thought-out strategy. If you need help in developing one, please feel free to reach out!
At Israilov Financial, we believe your investment strategy should align with your unique goals, risk tolerance, and financial aspirations. Whether you prefer the hands-off approach of passive investing or the tailored opportunities of active management, we’re here to guide you every step of the way. With our transparent, flat-fee structure and commitment to personalized advice, we help you make informed decisions that build lasting wealth. Ready to find the strategy that works best for you? Schedule your complimentary discovery meeting today.
IMPORTANT DISCLAIMERS
Past performance is no guarantee of future returns
The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.
This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.
Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.
As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.
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