Passive Notches More Winning Against Active

The point of this exercise isn’t to pile on the failings of active management nor is it too heap copious amounts of praise on passively managed funds.

Advisors know that both styles can fit well into client portfolios and there are market settings and asset classes that are conducive to active management. Turbulent environments, such as 2022, should be examples of active prowess, but data indicate that was not the case, particularly when pertaining to fixed income and real estate funds.

Yes, the Federal Reserve and its seven interest rate hikes played significant roles in the failings of rate-sensitive asset classes last year – active and passive. Indeed, tightening of monetary policy is a legitimate reason for slack equity and fixed income performance in 2022, but arguably, it should have also provided some runway for active managers to outperform. Data suggest otherwise.

Looking Into Active’s Tepid 2022 Performance

It’s often said, probably too much, that “it’s a stock picker’s market.” It’s debatable if that was the case in 2022, but the fact is active advantages were negligible at best last year.

“When viewed as a whole, active funds had less than a coin flip’s chance of surviving and outperforming their average passive peer in 2022, although results varied widely across asset classes and categories,” writes Morningstar analyst Bryan Armour. “For example, U.S. stock-pickers handled volatility much better than foreign-stock funds. The former cohort outgained its average passive peer 49% of the time in 2022, while only 34% of the latter group succeeded.”

Those percentages were even worse in the fixed income space as just 30% of active bond funds beat their benchmarks in 2022. Going further into the bond universe, fewer than a quarter of active corporate bond funds beat benchmarks in 2022, according to Morningstar.

Admittedly, one year is not an adequate test of the active/passive debate. Advisors should demand more extensive data sets and rightfully so. Thing is the longer-ranging data for active management isn’t encouraging.

“Longer horizons provide stronger signals that investors can incorporate into their selection processes. In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons. Only one out of every four active funds topped the average of their passive rivals over the 10-year period ended December 2022,” adds Armour.

Predictably, active success – when it’s attained – varies by asset class with long-term data suggesting it’s more pronounced with bonds, international equities and the real estate sector.

Punishment for Picking Losing Active Funds

Whether it’s an advisor doing it on behalf of clients or an individual investor going it alone, active fund distributions amplifying the punishment incurred for selecting laggard funds.

“Much like success rates, these distributions vary widely across categories. In the case of U.S. large-cap funds, the distributions skew negative. This paints a bleak picture for active funds in these categories. They have low long-term success rates, while penalties are high for picking a loser (per the negatively skewed distribution),” concludes Morningstar’s Armour.

Translation: The lack of distributions and tax efficiencies afforded by some passive strategies are meaningful over the long-term and are tough mountains to climb for many active managers.

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