Does recent research on active mutual fund performance challenge conventional wisdom that: (1) the average fund underperforms passive benchmarks on a net basis; and, (2) individual fund outperformance does not persist. In their September 2018 paper entitled “Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds”, Martijn Cremers, Jon Fulkerson and Timothy Riley review academic research on active mutual funds from the last 20 years to assess the degree to which it supports this conventional wisdom. They focus on U.S. equity mutual funds but also consider bond funds, hybrid stock-bond funds, socially responsible funds, target date funds, real estate investment trust (REIT) funds, sector funds and international funds. Based on this research, they conclude that:
- Over the past 20 years:
- The share of equity funds managed passively has grown from less than 8% to over 40%.
- The average expense ratio for active funds has decreased by about 20%, from 1.06% in 2000 to 0.78% in 2017 for equity funds and from 0.78% to 0.55% for bond funds.
- Indirect costs of trading within actively managed equity funds have fallen, with average annual turnover only 34% as of 2016.
- For equity funds, some research indicates that:
- Widely used factor model benchmarks understate active fund performance.
- Reverse survivorship bias (accruing all past bad luck) understates active management skill.
- Investment management firms can identify skilled fund managers.
- There are some truly outperforming funds, and ways for investors to identify them.
- Some fund managers can select outperforming stocks, and get rid of underperforming stocks.
- While market timing skill is difficult to measure, some managers exhibit it.
- Some fund managers dig deeper into firm information and handle information more effectively than other investors.
- Some fund managers add value through tax management.
- Some fund managers are more disciplined in avoiding emotional drags on investment performance than other investors.
- Studies that ignore the impact of economic/market conditions understate fund manager skill.
- The assumption that the market portfolio is static understates fund manager value.
- Alternative measures of fund manager skill show that some fund managers have skill and that the average active manager outperforms.
- There is conflicting evidence that fund size relates negatively to performance.
- For non-equity funds:
- The average bond fund underperforms benchmarks considered, but there is no widely accepted bond risk model.
- Findings regarding performance of hybrid stock-bond, socially responsible and REIT funds are mixed.
- Benchmarking of target date funds is difficult, and it is unclear whether active target date funds create value for investors.
- There is evidence of stock-picking ability, but not market timing skill, among sector funds. Results are sensitive to choice of benchmark.
- Many unique factors make the process of evaluating active international funds difficult.
In summary, recent academic studies suggest that conventional wisdom regarding the (lack of) value of active mutual fund management may be too negative.
Cautions regarding conclusions include:
- Approaches to measuring the value of active management become increasingly elaborate/conditional over time, making it:
- Seem like the investment management industry “doth protest too much” in justifying its value.
- Harder and harder for investors to exploit findings. In other words, the challenge of identifying outperforming fund managers in advance is daunting.
- The body of research largely measures fund performance against passive benchmarks and not against self-directed active investing.
