Triple Threat Three Challenges Facing Active US Equity Funds
In 2019, many active US equity strategies suffered from capital gains, underperformance and/or high fees.
As a result, investors are shifting to other vehicles, including ETFs—a trend we expect to continue.
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.
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.
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.
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.