Last Updated Apr 14, 2017 3:00 PM EDT
Many of the money managers who are paid big bucks to manage mutual funds held in millions of retirement accounts aren’t earning their pay. The reason is that they trail the market.
Over a 15-year period ending in 2016, more than 90 percent of money managers underperformed their benchmark indexes such as the S&P 500, a metric used to determine whether they did better than the market. In the year ending last December, 66 percent of large-cap managers, 89.37 percent of mid-cap managers, and 85.54 percent of small-cap managers fared worse than their benchmarks. S&P found similar results in June.
Fund companies have traditionally made the stock-picking skills of their managers a focal point of their marketing to prospective investors of so-called actively managed funds. Index funds seek to mirror the performance of the larger market by simply buying all of the stocks in a particular benchmark, known as passive investing due to its automatic nature, .
Index funds tend to have lower fees than active funds, because they don’t require legions of high-paid portfolio managers and analysts trying to ferret out opportunities. Financial experts have debated the merits of active versus passive investing for decades. These days, however, passive funds are benefitting from the missteps of active funds.
“Generally speaking, active managers have had difficulty adding value about an appropriate benchmark,” said Ben Johnson, director of global exchange-traded funds research at investment research firm Morningstar, in an interview. “There is no real consistency. Even among the best managers, there are going to be periods during which they are going to perform poorly compared to their benchmarks.”
About $285 billion was yanked from actively managed U.S. funds during the first 11 months of 2016 while $249 billion poured into index mutual and exchange-traded funds. Money managers are being hurt by the shift in investors’ sentiment. BlackRock (BLK), the biggest asset manager, recently announced job cuts as it automates its stock-picking business. Other fund companies such as State Street (STT) and Franklin Resources (BEN) have also cut jobs in recent months.
Even the fortunate few managers whose stock trading prowess outshines indexes are having trouble keeping investors happy. A recent Morningstar report estimated that a net $99 billion was pulled from “winning” active funds in the year ending Jan. 31, mainly from U.S. equity funds.”
Sometimes investors’ patience is rewarded when managers find bargain stocks that have fallen out of favor with Wall Street and are able to resell them at a profit later, even if it means their performance will temporarily lag behind their benchmarks. Sometimes, as with billionaire Warren Buffett, their patience is rewarded. Other times, they can lose billions.
That was the case with activist investor Bill Ackman’s bet on Valeant Pharmaceuticals (VRX). Ackman sold his large position in Valiant last month, booking a huge loss, and described his investment with the company as the worst performance of his career. Amid criticism that it over-priced its drugs and federal fraud investigations, Valeant saw its stock slide 96 percent over the past two years.
Steve Deschenes, director of client analytics at Capital Group, the parent of the American Funds ($1.3 trillion under management), cautions investors against abandoning actively managed funds entirely. Otherwise, he says, they risk losing out on potential gains. A $10,000 investment in the Vanguard 500 (VFINX) index fund, the largest of its kind, when it launched 40 years ago, earned more than $600,000 by now. But in a study Capital did, the five American Funds that have been around as long as Vanguard 500 did better than the Vanguard fund. They generated from $800,000 to about $1.4 million.
“Active in the aggregate isn’t how people invest,” he said. “The question isn’t do 20 percent, or 30 percent, of managers do better than the index. The question is can you identify the 20 percent or 30 percent of managers who do.”
Though past performance doesn’t indicate future returns, low fees and the level of investment that managers have in their funds are metrics relevant in picking funds, according to Deschenes.
One thing is for sure: The debate over active versus passive investing isn’t going to be settled anytime soon.