Success rate of active funds failed to impress in falling markets

In the latest monthly column, a Morningstar analyst runs through how funds fared against passive peers in 2022, a period that saw various stock markets fall sharply.

The invasion of Ukraine, high inflation, and the end of a decade-long period of ultra-low interest rates caused a perfect storm for the global financial markets in 2022.

Both the Morningstar Global Equity Index and the Morningstar Global Core Bond Index closed the year with a 17% to 18% decline. While volatile market conditions are seen as fertile soil for delivering alpha, the average success rate of European active managers against their passive counterparts failed to impress.

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We recently published the latest instalment of the Morningstar Active/Passive Barometer with data for calendar year 2022. This report measures the performance of European active funds against passive peers in 43 equity and 23 fixed-income Morningstar categories encompassing around 26,000 funds that account for €5.1 trillion (£4.5 trillion) in assets, or about half the European fund market.

The report showed that on average only 30.5% of active equity managers outperformed their average passive peer in 2022.

Energy stocks the big winners for markets

2022 was a very difficult year overall for equity markets. However, not all economic sectors closed the year in the red. Indeed, energy returned 47.6% on average, proving one of the few safe bets. By contrast, it was a terrible year for the very popular technology sector, which posted an average fall of 30.8%.

When viewed as a whole, active equity managers funds had less than a coin-flip’s chance of outperforming, although results varied widely across categories. For example, almost half of stock pickers in the UK equity income category outperformed, compared to just a fifth in the UK large-cap and mid-cap segments. However, of all equity categories we analysed, a mere three showed a one-year rate of success for active managers, at or above 50%.

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Active bond managers fared better

Active bond fund managers showed higher success rates relative to passive peers than their equity counterparts in 2022. The average success rate in the 23 bond categories we studied stood at 46%. And nine categories, among which was GBP corporate bond, delivered a one-year success rate for active managers at or above 50%.

Shortening bond duration was an effective way for active managers to cushion the losses brought about by the rise in interest rates. By contrast, the average passive peer tracking an all-maturity index and with no flexibility to deviate from the benchmark, was at a clear disadvantage in that environment.

Look to the long-term numbers

One year isn’t a sufficient time horizon from which to draw firm conclusions about the ability of active managers against their passive competitors. Success rates can fluctuate wildly from one year to the next depending on what goes on in the markets and how active managers react to events.

Longer time horizons provide stronger signals that investors can incorporate in their fund selection process, and here the results are conclusive. The average rate of success for active equity managers in the 10-year period through December 2022 was 23%, while for active bond managers it was 19%.

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Only three equity categories - global equity income, UK equity income, and Switzerland small/mid-cap equity - delivered a success rate for active managers over 50%. A key driver for the success of equity income managers was successful bets on energy coupled with underweights in companies from the consumer discretionary, communication services, and technology sectors.

Meanwhile, in the case of active bond managers, we find that they tend to take more credit risk than their passive peers over longer periods. Their success rates tend to rise when this risk is rewarded and fall when credit spreads widen, as they did last year.

Survivorship bias

The biggest driver of active funds' failure is their inability to survive over long periods. This is often the result of lacklustre performance. This can be explained by a mix of wrong stock-picking decisions and the compounding negative effects of higher fees relative to their low-cost passive competitors.

Our analysis shows that the average 10-year survivorship rate for active equity and fixed-income funds stands at around 50%, while for passive funds it is closer to 70%.

 Dimitar Boyadzhiev is a senior analyst at Morningstar.