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The Debate Goes On: Active Vs Passive

May 04, 2020 8:09 AM ET
Tom Roseen profile picture
Tom Roseen
1.67K Followers

Summary

  • The perennial debate over passively versus actively managed funds continues.
  • Passively managed funds underperform their benchmarks more frequently than their actively managed counterparts, but they underperform their benchmarks by a smaller magnitude.
  • Actively managed funds generally have a higher beat rate with both larger median excess returns and losses than their benchmarks.
  • For Q1 2020, we see that during the recent market meltdown actively managed equity funds were able to mitigate losses better than passively managed equity funds and ETFs.
  • Historically, both camps have offered sound reasoning for embracing one investment practice over the other. But they both might be right.

Photo Source: REUTERS/Michael Buholzer. Teams from different nations compete in the Tug of War World Championships in the town of Appenzell, Switzerland.

The perennial debate over passively versus actively managed funds continues. Historically, both camps have offered sound reasoning for embracing one investment practice over the other. But they both might be right.

Relative Performance: Active vs Passive

On one hand, the argument goes, investors benefit from the low expense ratios and low portfolio turnover of passively managed funds, which bring passively managed mutual funds’ and ETFs’ total returns very close to their index benchmarks. However, in about 84% of the relative performance observations (fund return minus the benchmark return), passively managed funds underperformed their benchmarks after taking expenses and cash drag into account, with a median excess loss/underperformance of their benchmark of just 51 basis points (bps) for 2019. For the remaining 16% of the relative performance observations, the median excess gain/outperformance of their benchmarks was 41 bps for 2019.

On the other hand, while actively managed funds are often cited as having a difficult time outperforming their benchmark because of higher relative expense and portfolio turnover ratios, we note that actively managed funds have a higher likelihood of outperforming their benchmark than their passively managed cohorts. About 43% of actively managed funds beat their benchmarks in 2019, with a median excess gain/outperformance of their benchmarks of 225 bps. For the remaining 57% of relative performance observations, actively managed funds underperformed their benchmark by 296 bps.

What were the actual returns?

When the market is firing on all cylinders, it makes sense that it becomes more difficult for an actively managed fund to consistently outperform its benchmark (a rising tide lifts all boats), requiring the active manager to add enough alpha to compensate for the fund’s higher relative expenses and cash drag (those

This article was written by

Tom Roseen profile picture
1.67K Followers
Tom Roseen is the Head of Research Services, joining from Janus in 1996. He is the editor and an author of Lipper's U.S. Research Studies, FundFlows Insight Reports and FundIndustry Insight Reports. He is involved in fund analysis and research, and contributes to the monthly and quarterly equity and fixed income FundMarket Insight reports, webcasts and podcasts, where he focuses on domestic and world fund performance and attribution. His areas of expertise include closed-end fund analysis, portfolio evaluation, equity and fixed income fund research, fund flows analysis, after-tax performance and Lipper Leaders. Tom has a BS in finance from Metropolitan State College of Denver and a Master's in International Management from the University of Denver.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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