Active funds: frequent underperformance, higher expenses and underrated risks

The scale of passive funds is growing. Passive funds now account for 32.5% of US assets managed in mutual and exchange traded funds. According to data from Morningstar, $223.1 billion outflowed from actively managed funds; meanwhile, passive funds saw inflows of $418.6 billion in 2015.

For the year 2015, 66.1% of large-cap managers, 56.8% of mid-cap funds and 72.2% of small-cap managers underperformed their relevant S&P US benchmarks. Over long time periods, 82.1% of large-cap funds and 88.4 % of small-cap managers fail to match their benchmarks. Of all the 678 domestic equity funds in the top quartile for performance over the year to September 2013, only 4.3% stayed in the top quartile by the end of September 2015. This means very low persistency. 

There are two ways to earn higher returns: to find an excellent manager or an unbeaten strategy or to reduce the cost. It is proven that the former is easier said than done. On average, active funds will roughly match the index before fees; that means that after fees, most of them will lose to the index. Style Research’s survey provided evidence for it. Among 425 global equity funds, 31% of them outperformed the MSCI World. Without taking any costs into account, however, 59% of representative samples beat the index. That is to say, 28% of funds charged too much to maintain the beat-the index performance.

For those that do manage to outperform, size can become a problem. Strong performance attracts more money and larger funds find it much harder to beat the market. A research by Stambaugh found that the scale also affects performance and that a more skilled large fund can underperform a less skilled small fund.

Is there no end to liquidity?

Central banks have flooded financial markets with liquidity since 2008.

But not all central banks and banks implemented QE policies immediately. UK and US led QE activities because their economies were heavily dependent on financial system.

The initiate intention is to stabilize financial markets and provide liquidity so banks will not fail. But I thought the priority was to support aggregate demand.

This causes some divergence between monetary policy and fiscal policy. In the United States, they deployed aggressive monetary policy action to support sustainable growth and to minimize financial market instability. The divergence arises from various government’s claim to reform tax for corporates, infrastructure spending and investment plans. This causes a disjoint between monetary and fiscal policy.

This leads to credit market explosion. In US, Fed’s balance sheet is now close to 25% of GDP. The case of Japan is even more unimaginable. Credit markets have doubled over the past 10 years. This is a rational response to liquidity and low rates.

The chart above shows that the structure of bond markets has changed. Bonds are now increasingly held by mutual funds and other types of funds. This means less market making. This also means most funds have now acclimatized to high liquidity situations.

The key concern is the impact on these investors when rates eventually increase?

Will they systematically face more volatility? Will there be sufficient liquidity to unwind? Aggressive monetary policies can create asset bubbles. This is especially so in equity and credit markets.

Based on basic Keynesian models, the governments of the world should support policies that increase aggregate demand. An example is investing in infrastructure projects that will increase spending. I am worried if the only plan is to continue increasing liquidity.