Market volatility is supposed to give sophisticated, active traders an edge over passive investors—an opportunity to shine and prove that active managers are worth the fees they charge.
But that’s not how things panned out during the COVID-19 crisis, according to Chicago Booth’s Lubos Pastor and Booth PhD candidate M. Blair Vorsatz. The researchers document crisis-period underperformance, which creates an additional headwind for the active-management industry.
Many active managers have been struggling to justify their services. Low-cost index investing has been gaining ground for years, and in August 2019, passively managed assets hit $4.27 trillion, edging out actively managed assets for the first time.
One explanation for the continued prevalence of active management is that while active funds underperform passive funds on average, this average underperformance is tolerated because active funds do better in bear markets, when investors value better performance the most.
However, this explanation does not hold up for the COVID-19 crisis. Pastor and Vorsatz analyzed daily returns from 3,626 equity funds between February 20 and April 30—a tumultuous 10 weeks when the S&P 500 index collapsed by a third before gaining nearly all of it back. The researchers find that, net of management fees, a large majority of actively managed funds lagged behind their respective benchmark indexes.
Three-quarters of active-fund managers underperformed the S&P 500, with average underperformance of 5.6 percent during the period, or 29 percent on an annualized basis, the researchers find. The broad index isn’t a suitable gauge for every fund, but active funds also trailed a variety of better-tailored benchmarks, though by smaller margins.
Depending on which valuation model they chose, the researchers find that between 60 percent and 80 percent of active managers lost money on a risk-adjusted basis relative to their passive benchmarks. “Regardless of how we look at the data, we see active funds underperforming during the crisis,” write Pastor and Vorsatz.
Little safety as pandemic assailed the markets
Active-fund managers underperformed not only the S&P 500 over the early months of the COVID-19 crisis but also benchmark indexes with comparable holdings.
While active funds underperformed on average, some fared better than others—specifically those with higher sustainability scores and performance ratings, both measured by Morningstar.
Sustainable investing looks beyond raw financial returns by including environmental, social, and corporate governance (ESG) factors in the security-selection process. Morningstar assigns each fund a sustainability score, measured in “globes,” with more globes denoting greater sustainability. Funds with more sustainability globes generated higher benchmark-adjusted returns than those with fewer sustainability globes, the researchers find. In particular, four- and five-globe funds had a 14 percent better average annualized benchmark-adjusted return than similarly styled funds with fewer globes.
Morningstar’s performance ratings—scored in stars, not globes—were another harbinger of returns. “It is not clear a priori why Morningstar’s star ratings, which are computed before the crisis from historical risk-adjusted returns, should have such strong predictive power for fund performance during the crisis,” the researchers observe. Nevertheless, they demonstrate that each extra star corresponded to a higher crisis-period annualized benchmark-adjusted return of nearly 6 percent—meaning that a five-star fund outpaced a one-star fund with the same investment style by 23 percent a year.
Globes and stars were also reliable predictors of changes in funds’ assets under management. One-globe funds shed 2.6 percent of their assets as customers withdrew funds, while five-globe funds suffered no net leakage, the researchers find.
“A popular perspective in traditional neoclassical economics is that sustainability issues, such as environmental quality, are ‘luxury goods’ that are likely to be of concern only to those whose more basic needs for food, housing, and survival are adequately met,” the researchers write. “That investors retain their focus on sustainability during a major crisis indicates that they view sustainability as a necessity, not a luxury.” As usual, funds with more stars also attracted more assets on the whole than those with fewer stars.
If most pricey money managers don’t add value, even in a crisis, why are so many still in business? One reason, the researchers suggest, is that investors believe active managers “face decreasing returns to scale”—that is, as funds underperform, they shed assets, which in turn improves their future performance. Whether active funds’ performance improves after the COVID-19 crisis remains to be seen.