Most Active Management Is Priced To Fail, Morningstar Argues

As investment fees and expenses continue to decline, many actively managed mutual funds look even worse after years of underperformance.

That’s because most active mutual funds are “priced to fail,” according to a recent report from Morningstar.

According to Jeffrey Ptak, head of global manager research at Morningstar, active mutual fund fees haven’t fallen as sharply as other investment expenses. As a result, more than two-thirds of U.S. equity funds carry expenses that would wipe out their estimated future pre-fee excess returns.

Of the 6,708 active U.S. equity mutual funds in the Morningstar database, 4,635 were not projected to outperform net-of-fees. Ptak points out this is not a small cohort of obscure mutual funds—the group that underperforms its benchmark net of fees accounts for $2 trillion in assets.

Fund overpricing was most common among U.S. large-cap funds, and least prevalent among U.S. small-cap funds, according to Ptak’s analysis.

Many of the remaining third of actively managed mutual funds, which carry expenses less than Morningstar’s estimates of future returns, have slim margins of error, with most of the funds posting fees no more than 0.3 percent below their potential future outperformance.

When Ptak excluded funds that levy 12b-1 fees for marketing and distribution costs, the results didn’t change—most active funds, 1,773 of 3,246, were still priced to fail over the long run.

Fee compression isn’t the only trend ailing active management. Declining returns across many asset classes and categories make investment picking a difficult task, as pre-fee excess returns have dropped below historical averages, writes Ptak. At the same time, the standard deviation of excess returns has declined, meaning that active managers are less likely to differentiate themselves through their outperformance.

Ptak predicts the low likelihood of outperformance will force many of the managers in his analysis to lower fund expenses or mothball poorly performing funds.

To carry out his analysis, Ptak examined annual expense ratios and compiled rolling pre-fee excess returns for every U.S. open-ended fund in the Morningstar database for 10-year periods ending October 2006 through October 2016. Excess returns were calculated by subtracting each fund’s gross annualized returns from the returns of the benchmark assigned to its Morningstar category.