Active vs. Passive Debate: What Does the Data Tell Us?

Investors for years have been debating which type of investment strategy is better: active or passive. In trying to answer this question, it can be helpful to consider the data.

In the past, we have evaluated the persistency of top-quartiles mutual funds across 17 categories. Given the increase in the number of index funds in the current 10-year period ending December 2018, we have updated the results separately for active and passive.

The recent evaluation shows:

  • 83% of 10-year top-quartile active managers were unable to avoid at least one three-year time period in the bottom half of their peer group. This is the lowest result to date, relative to 92%, 90%, 85%, and 89% in our 2015, 2012, 2010, and 2007 studies, respectively. We believe the most recent lower outcomes is partially driven by no material drawdown in the most recent 10-year period, a unique circumstance compared to previous studies.

  • Top-quartile active managers on average spent 6.2 consecutive quarters below the median of their peer group.

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Most Managers Will Struggle at Some Point

Our findings remain consistent and support our previous conclusion that the majority of the best managers over longer periods of time will periodically struggle relative to their peers. While fewer active managers are breaching the bottom half of the peer group over the recent 10-year time period on a relative basis, on an absolute basis the number is still high.

Our findings continue to suggest investors who select and terminate active managers based on short-term performance results are likely to miss the highest long-term performers.

The Role of Large Cap Equities and Intermediate Bonds

An investor might ask how more top-quartile managers have persistently stayed above the peer group median. Given the rise of passive investing through the last 10-year bull market, our findings indicate this phenomenon is largely driven by Large Cap equities and Intermediate Bonds.

We found top-quartile managers in Intermediate Bonds allocated more to spread sectors such as credit over the last 10 years, with allocations to securities rated BBB and below averaging 11% higher than the peer group median. In Large Cap equities, most index funds never dropped below the 50th percentile. As such, managers that exhibited less market risk were destined to decline in peer group ranks, as managers that took on at least full market risk were able to compete with the index.

Finally, the 10-year period ending 2015 is far different from the current period, in that maximum drawdowns and duration of drawdowns were less pronounced as we move further away from the Great Financial Crisis in 2008.

Passive Investing Doesn’t Always Outperform

Furthermore, we examined the performance patterns of index funds with 10-year track records and found that passive investing does not always outperform the peer group median. Of the 17 asset classes included in the study, Large Cap Value, Core, Growth, and Mid Cap Core were the only asset classes that had index funds avoiding a three-year time period in the bottom half of their peer groups.

Our findings indicate that index funds in the remaining 13 asset classes were unable to shield investors from volatility in relative performance compared to active peers, as index funds spent, on average, 24% of rolling three-year time periods in the bottom half of their peer groups – despite the advantage of a lower fee. The following chart illustrates the relationship between relative performance to peer group rankings, which displays a sample of asset class’ rolling three-year batting average over the last decade.

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Our observations include:

  • 100% of top-quartile Intermediate Bond active managers outperformed their index rolling three-year periods generating positive excess return.

  • By contrast, top-quartile Large Cap Core active managers only outperformed 55% of rolling three-year periods – only slightly better odds than flipping a coin. These findings illustrate how passive investing proves to be a superior alternative in certain asset classes where active managers are more likely to underperform.

Patience Required

As our data suggests, both the path to outperformance and the probability of outperformance are important elements for investors to consider. With 83% of top- quartile mangers finding their way into the bottom half of their peer group for at least a three-year period, it suggests patience is required for success with active management.

Moreover, the likelihood of success for active management is not uniform. Investors may benefit to minimize exposure to areas where the probability of success for active managers is low and take advantage of those areas where success rates are higher.

If you have questions about your active or passive investments, contact an advisor at Fi3 today.