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  • Despite market conditions in 2013 that seemed friendly to active funds, fewer than anticipated outperformed their benchmarks, according to research from Vanguard's Investment Strategy Group.
  • A tendency to chase performance, combined with a wide dispersion of fund returns, diminished clients' chances for beating indexes.
  • Investors who choose active funds should consider those with low costs.

As 2013 progressed, prospects seemed bright for active management. After many years of anticipation, interest rates finally began rising, theoretically setting the stage for active bond fund managers to outperform. In the U.S. equity market, correlations between individual stocks fell, creating opportunities for stock pickers.

But even though active managers were planting seeds in seemingly fertile soil, many still struggled to beat their benchmarks. According to data provided by Morningstar, only 48% of active managers of diversified fixed income funds outperformed in 2013. The record of active stock-fund managers was similar, with 50% beating their indexes. Of course, one year isn't long enough to judge the performance of any type of investment, but Vanguard decided to look at 2013 because many investors believed conditions then were ripe for active outperformance. The analysis reinforced Vanguard's long-standing beliefs about active management, said Brian Wimmer, an investment analyst in Vanguard's Investment Strategy Group (ISG).

"In 2013, it was really difficult to determine, based on market conditions, whether active managers would do well or do poorly," Wimmer said. "This result is consistent with our research showing that active outperformance is difficult to predict and that, on average, active funds have had regular periods of market-lagging returns."

A surprise in emerging markets

Although half of active equity funds trailed passive equity funds in 2013, there was at least one category where outperformance was more common: About 56% of active emerging markets stock funds beat their benchmarks, according to data provided by Morningstar.

"If there were an environment where active managers could be excused for underperformance, this would be one," said ISG Senior Analyst Chris Philips. "After besting U.S. stocks for many years, emerging markets equities saw not only significant underperformance in 2013 compared with U.S. stocks, but also negative returns [MSCI US Investable Market 2500 Index, +33.5%; MSCI Emerging Markets Index, -2.3%].1 Despite these conditions, active managers in this category, on average, managed to overcome this tumult and deliver excess returns."

Even with the benefit of hindsight, it's difficult to pinpoint the exact reasons that, over short time frames, active may beat passive in one category while failing to do so in others. And that was the challenge of picking outperformers in 2013. On one hand, you had emerging markets stock funds, which conditions suggested were ripe for active underperformance, and on the other, fixed income funds, in a rising-rate environment that presumably favored the active. But the reality was that active emerging markets managers outperformed while active fixed income managers underperformed.

The 2013 results for bond funds duplicated findings from Vanguard research. While many clients assume actively managed bond funds will outperform their benchmarks when interest rates are rising, the data suggest otherwise.

"Even when fixed income managers are correct in believing that rates will rise, they still must correctly gauge the timing and size of rate increases across the yield curve to position their portfolios to surpass benchmarks," said ISG Investment Analyst James Balsamo. "As the returns show, that's been a difficult task."

Challenges to active outperformance

First, the wide range of returns among active funds increases the risk involved in picking a winner.

As the figure below shows, in 2013 an emerging markets equity investor could have picked a fund that beat its index by 12.47% or one that lagged it by -12.85%. Selecting the right manager was not only crucial to success but also difficult.

Dispersion of excess returns can be large when using active management

Notes: Categories for U.S. domestic equity include large blend, large growth, large value, mid blend, mid growth, mid value, small blend, small growth, and small value. Diversified fixed income categories include U.S. short-term corporate, U.S. intermediate-term corporate, U.S. short-term government, and U.S. intermediate-term government. Excess returns were based on funds' stated prospectus benchmark. All share classes are represented with the exclusion of funds that did not survive.

Source: Morningstar, Inc., with Vanguard calculations, period from January 1, 2013, to December 31, 2013.

Active managers aren't the only ones underperforming. Investors' tendency to chase performance means they usually don't achieve the full returns of their active funds. A Vanguard analysis of 2013 active fund performance and cash flows suggests that investor returns were less than fund returns (see the figure immediately below). Among diversified fixed income funds, for example, poor market-timing meant investors earned 74 basis points less than the fund return.

Performance-chasing behavior decreased returns realized by investors

The amount by which investors' returns differed from those of the funds they were invested in as a result of the timing of their cash flows throughout the year.

Notes: The difference is calculated based on Morningstar data for investor returns and fund returns. Morningstar Investor Return™ assumes that the change in a fund's total net assets during a given period is driven by both market returns and investor cash flow. To calculate investor return, the change in net assets is discounted by the fund's investment return to isolate the amount of the change driven by cash flow; then a proprietary model is used to calculate the rate of return that links the beginning net assets and the cash flow to the ending net assets. See the previous figure for additional notes regarding fund categories.

Source: Morningstar, Inc., with Vanguard calculations, period from January 1, 2013, to December 31, 2013.

Improving the odds of active management success

Vanguard believes that while there are no criteria that guarantee the selection of talented active managers, investors can improve their chances by paying attention to certain factors. The most critical quantitative factor is low costs. Vanguard studied the relationship between fund fees and returns over the 15 years ended December 31, 2013 and found that lower costs led to higher returns (see the figure below).

Investors interested in active management can generally increase their odds of outperformance by selecting low-cost funds

Difference in excess median returns of least expensive quartile funds and most expensive quartile funds. A positive figure indicates the median return was greater in funds that were less expensive.

Notes: Expense ratios are based on prospectus expense ratios. See first figure for additional notes regarding fund categories. The "least expensive quartile" is the top 25% of funds that have the lowest expense ratios in a given Morningstar category. The "most expensive quartile" is the bottom 25% of funds ranked by expense ratios in a given Morningstar category.

Source: Morningstar, Inc., with Vanguard calculations, periods ended December 31, 2013.

Low costs alone, however, do not always lead to active success. In addition to considering costs when selecting active management, Vanguard looks for experienced, talented managers with effective investment strategies that have the potential to be executed successfully over the long run. Vanguard also is committed to developing long-term relationships with the external managers that advise most of our active funds. Our average relationship with a manager is more than 13 years.

Vanguard believes that our adherence to these principles explains why the median results of Vanguard active funds compare favorably with the universe of other available actively managed funds.2

Teaming active and passive

For advisors and clients who prefer active management, a portfolio that uses broad-market index funds as the core holdings and selected actively managed funds as satellite holdings can moderate exposure to volatile relative returns while maintaining the potential for outperformance.

The mixed performance of active funds in 2013 broadly supports what we've said previously about active versus passive management.

"We don't view the active versus passive discussion as an either-or question," Wimmer said. "Active and passive approaches can be effective as long as investors utilize low-cost funds and remain disciplined over time. High costs and performance-chasing drastically reduce the odds of investors' achieving investment success."

1 Vanguard and MSCI data.

2 For the ten years ended September 30, 2013, 35 of Vanguard's 38 active equity funds (92%) outperformed their peer group's average annual return, based on data from Lipper, a Thomson Reuters Company. Note that the competitive performance data shown represent past performance, which is not a guarantee of future results, and that all investments are subject to risks. For the most recent performance, visit our website at


  • All investing is subject to risk, including possible loss of principal.
  • Past performance is no guarantee of future returns.
  • The performance of an index is not an exact representation of any particular investment, since you cannot invest directly in an index.
  • Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.