As Mark Twain might quip, “The death of actively managed funds has been greatly exaggerated.” While it’s old news that actively managed funds have been bleeding assets, there are select pockets of strength where managers trying to beat their index benchmarks have excelled.
A study by VanEck that spanned from 1996 to 2015 found that more than half of actively managed funds within the Morningstar Diversified Emerging Markets universe outperformed the MSCI Emerging Markets Index. Moreover, top-performing funds within that Morningstar universe—funds in the 25th percentile—beat the benchmark by an average of 4.73% on a net basis annually during the 20-year study. Advisors searching for alpha should consider emerging markets as a place where paying extra for active management might pay off.
But to quote an old investing maxim, “past performance is no indicator of future performance.”
A S&P Dow Jones Indices study on performance persistence that covered a five-year period ending March 2019 found that a sizable percentage of top-performing funds were likely to become bottom performers rather than maintain their leadership. For example, in the domestic equity category 15.3% of the bottom-performing funds moved into the top quartile. Meanwhile, a much larger percentage of top-performing funds (31.5%) lost their winning touch and moved into the bottom quartile.
As per the S&P Dow Jones Indices study, perhaps the biggest strike against active management was the inability of managers to sustain their outperformance over longer time periods. For instance, no large-, mid- or multi-cap equity funds kept their status as top-quartile performing funds at the end of the five-year period.
The inconsistency of active managers is frustrating because most investors seek reliability, and a lack thereof is one reason why asset flows favor index-based ETFs.
The top 20 asset gathering ETFs this past June were all index funds. The top three were the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), iShares Short Treasury Bond ETF (SHV) and SPDR S&P 500 ETF (SPY). These three funds combined to take in $12.4 billion in June, according to ETFGI.
How can financial advisors make the best of these asset flow trends in their business?
Using index ETFs for a portfolio’s core while using active management for satellite or non-core positions is one technique that blends both strategies into one portfolio solution. That enables advisors to hedge against the risk of underperforming the market by utilizing passively managed ETFs while cherry picking investment categories where active management might offer outperformance.
Active managers have struggled to outperform during all market cycles, both good and bad. And if history is any guide, that probably won’t change going forward. That said, active management can still add alpha in certain areas of the market
Ron DeLegge is founder and chief portfolio strategist at ETFguide.