Triple Threat Three Challenges Facing Active US Equity Funds

The phrase “Ball doesn’t lie” is a basketball term, first uttered by former New York Knicks forward Rasheed Wallace. And in my view, it very much applies to today’s fund industry.

The ringer.com explains¹ the meaning and usage of the “ball doesn’t lie” expression as,

“If a foul call is disputed by the guilty party, then the ball will have final say over whether the call was right or wrong. If the shooter misses one or both foul shots, then the ball has revealed that there must not have been a foul. If the shooter makes both shots, then there must have been a foul. The ball doesn’t lie.”

The Big Three Posting Up the Fund Industry
So how does this apply to the fund industry? Flows, in this case, are the ball. And based on the trend of assets moving from mutual funds to Exchange Traded Funds (ETFs) over the past decade, investors seem to prefer ETFs. Flows don’t lie.

While assets have grown by $1.9 trillion over the past decade for US large-, mid-, and-small-cap active equity mutual fund strategies, it has all been from market appreciation, as investors have redeemed $1.3 trillion over the last 10 years.² Broad based underperformance trends are a common reason cited for the redemptions, but it’s not the only reason. Capital gain dividends³ and high fees round out the “big three”. However, unlike the “big three”⁴  that led the Boston Celtics to numerous titles in the 1980’s, this troika is leading to a shift in buying behavior to lower cost indexed-based vehicles, like ETFs.

Active US Equity Getting Dunked On By Poor Results…Again
Charging a high fee, underperforming a benchmark, or paying a capital gain are three reasons why an investor may be hesitant to either remain in a fund or even invest in the first place. But, for a fund to be guilty of all three at once, that is assuredly not a recipe for long-term success. Unfortunately, in 2019, there were quite a few active US equity strategies that had all three.

1. High Fees? In 2019, the average active US equity mutual fund charged 1.11% vs the 0.38% levied by US equity ETFs⁵. More details on that later.
2. Underperforming a Benchmark? In the below chart, you can see that active US equity funds in every Morningstar category⁶ had more than 50% of managers underperforming their prospectus benchmark in 2019. The only exception was in mid-cap growth – an area I discussed previously as being one segment where active management had shown some noticeable historical persistence. And for those managers that did underperform, they missed by a wide margin too. Like a rookie throwing up an air-ball. The average return differential versus their benchmark for underperforming managers ranged from -3.9% to -6.2%, depending upon the style box. Performance trends were a bit better outside the US⁷.
3. Paying Capital Gains? More than two thirds of active US equity funds in every Morningstar category⁸  analyzed paid a capital gain last year, as shown below – with some categories over 90%. Taken together, 5,343 out of 6,436 active US equity mutual funds (or 83%) paid capital gains in 2019, with the dividend averaging $1.48 per share. Foreign and emerging market active funds also paid capital gains in 2019, but their numbers were much less at 33% and 24%, respectively⁹. High capital gain percentages are not unique to 2019, as it’s a persistent trend for mutual funds in general.
   

A Double Technical
Not every US active equity manager that paid a capital gain also underperformed. But, for the most part, they did – especially among large-cap managers. Across each style bucket (growth, blend, and value), more than 60% of the respective large-cap active universe underperformed AND paid a capital gain (see chart below). The other market cap styles had lower percentage amounts, but were still above 30%. Altogether, this equates to $3 trillion of assets invested in active US equity mutual fund strategies across large-, mid-, and-small-cap styles that paid both a capital gain and underperformed their benchmark.

Having a high percentage of managers underperforming and then paying out a capital gain is bad enough, but throw in a high fee and it makes matters worse. It’s like getting a double technical for a hard foul then yelling the “ball doesn’t lie” after the opposing player misses the shot – only to then get another technical for that¹⁰.

For the large-cap segment, the average fee charged by the 60% of managers was approximately 90 basis points (bps), as shown above. In the mid- and small-cap space, the fees were higher, topping out at 115 bps. Given the asset levels ($3 trillion), this translates to $22 billion of fees paid last year to managers that both paid a capital gain and underperformed their benchmark by over 4% (and that doesn’t even include costs related to taxable distributions!). As an investor, that experience is likely about as fun as when I sat through the 58 loss 2006 Boston Celtics season.

Now compare this to the ETF universe of the similar US equity market styles: 

• Only 5% of US equity strategies paid capital gains in 2019, many of which were newer strategies¹¹
• Performance is tied to an index and slippage is likely limited--particularly for broad market beta strategies that active funds seek to outperform¹²
• Fees, on average, are 38 bps, with some as low as 3 bps for broad market beta¹³

Flows Don’t Lie
If proposed with the option to invest in something that charges a high fee, negatively impacts your tax bill, and also underperforms its stated goal by a wide margin vs. a lower fee, more tax efficient, and closer to benchmark performance, which one would you pick?

Investors have clearly chosen ETFs in the 2010’s, as like the ball, flows don’t lie. It’s been nothing but net for ETFs.

Expect that to continue and accelerate in the 2020’s for three reasons:

• Continued lower cost and tax efficiency relative mutual funds¹⁴;
• Increased track record for transparent, cost efficient, systematic factor driven ETF strategies (e,g, value, quality, momentum) which can replace high fee, active;
  

And use of model portfolios (which is actively-managed at the sector, country, regional, or asset class level).