When to use Active Mutual Funds vs Passive ETFs

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Difficulty: Easy

1) There is growing consensus that active mutual funds tend to underperform passive mutual funds & ETFs

According to Morningstar, only 23% of all active mutual funds had outperformed their passive mutual funds & ETF rivals in the last 10 years. However, we should seek to understand the nuance behind this result.

2) Indeed, active mutual funds focused on US stocks have underperformed their passive peers…

For Global/US Stocks, active mutual funds have generally done worse than passive mutual funds & ETFs, underperforming by up to 2% annually.

3) But active mutual funds for many other categories outperformed their passive peers!

For other categories (e.g. non-US stocks, Emerging Markets, Bonds), active mutual funds have generally outperformed passive mutual funds & ETFs.

4) Fees matter a lot when choosing an actively managed mutual fund

If we ignore categories, as a whole, both cost-efficient and cost-inefficient active mutual funds underperform passive vehicles. However, 34% of cost-efficient active mutual funds outperform passive peers, vs. 14% of cost-inefficient mutual funds outperform peers. This suggests that if one decides to pick an active mutual fund, it’s better to pick one with a low Total Expense Ratio.

The InvestQuest’s View: For diversified exposures to Global and US stocks, stick with low-cost passive mutual funds & ETFs. For exposure to non-US stocks, emerging markets and corporate bonds, I would suggest a cost-efficient actively managed mutual fund.

If you find this article useful, do feel free to check out our other ETF and Mutual Fund related articles too!

(OPTIONAL) Key differences between Mutual Funds and ETFs

According to Investopedia, a mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities. In many ways, it is very similar to an ETF, providing you with the benefits of diversification. However, there are clear distinctions to be made.

Investment objective:

The investment objective depends on the type of mutual fund.

There are two main types of mutual funds: one is actively managed (“active mutual funds”) and the other is a tracker fund (“passive mutual funds”) that aims to replicate the performance of a chosen Index.

Active mutual funds aim to outperform a chosen benchmark, which is typically an index. This outperformance may be achieved via stock selection or intentional portfolio tilts towards specific sectors/geographies/styles.
Passive tracker mutual funds aim to match the index returns, before any fees or expenses are charged.
Similarly, ETFs also aim to match index returns, before any fees or expenses are charged.
Note: In recent years, there has been launches of “nontransparent ETFs”, which are essentially actively managed ETFs. We will not cover this further in this article as it’s still a relatively new product class.

Trading convention:

Both active and passive mutual funds are bought and sold by investors at the fund’s daily net asset value (NAV). If you place a buy or sell order, you will transacting at that day’s NAV, which will be published only on the next day. There is no option to place limit orders for mutual funds.
ETFs are bought and sold like a stock, so you will be able to place limit orders and the ETF market price can fluctuate through the trading day.
The ETF price may also deviate from the actual NAV of the ETF holdings.

Fees:

Total expense ratio: This recurring cost will be deducted directly from the fund/ETF’s NAV.
Actively managed mutual funds tend to a have a higher total expense ratio than passive mutual funds/ETFs.
One-off fees: Depending on your mutual fund distributor, the upfront sales charge may be anywhere between 0% to 3%. This is typically paid on purchase, with no fees payable for redemption.
For ETFs, you will pay the brokerage commission similar to how you would for a stock for each of the buy and sell transactions.

Transparency

ETFs tend to be more transparent and disclose their holdings on a daily basis.
Generally, both passive and active mutual funds tend to only disclose their holdings on a monthly basis.

There is growing consensus that active mutual funds are likely to underperform passive mutual funds and ETFs

The active mutual fund market has been under pressure for the past decade, as investors have flocked to lower cost ETFs (chart below). One key reason for this is a growing consensus that active mutual funds have not been able to outperform ETFs, net of fees.

Source: CNBC, retrieved 19 June 2020 from https://www.cnbc.com/2020/01/25/the-next-big-thing-in-etfs-could-give-a-boost-to-long-suffering-active-investors.html

The data shows this is true. But the underperformance doesn’t apply to all categories of active mutual funds.

According to Morningstar, only 23% of ALL active mutual funds managed to generate better returns than comparable passive mutual funds and ETFs, for the 10-year period up till end-2019.

However, there are some categories where the majority of active mutual funds have outperformed their passive peers.

The chart below shows the % of active mutual funds which have outperformed their passive peers, sorted according to different categories.

Example using first column: If there are a 100 US Large Cap Blend active mutual funds, only 8 of them outperformed their passive peers.

Source: Morningstar’s Active/Passive Barometer (December 2019), retrieved from https://www.morningstar.com/insights/2020/03/06/active-vs-passive-fund-performance

For all types of US stock active mutual funds (e.g. US Large Cap, US Growth, US Value), only a minority outperformed their passive peers. Refer to columns in the orange section, and see how all the bars are below 50%. This may be due to the US stock market being relatively efficient, making it harder for active managers to outperform the broader market.

Meanwhile, for some of non-US stock active mutual funds, the majority of the active funds outperformed their passive rivals. See the bars in green (more than 50%). These categories were Foreign Large Growth, Diversified Emerging Markets and High Yield Bonds.

Above, we looked at the % of funds that outperformed. When looking at asset-weighted excess return, we see a similar trend.

Asset-weighted excess return places more emphasis on the performance of larger active mutual funds and larger passive peers. This is more representative of what the average investor would have experienced as he/she would have been more likely to invest in the larger funds/ETFs.

On the flip side, asset-weighted excess return consequently places less emphasis on smaller active mutual funds. These funds to have a higher total expense ratio and as a result, struggle more to outperform passive peers.

The chart below shows the annual asset-weighted excess return for active mutual funds across different categories. If the number is positive, that means the active mutual funds have outperformed for that category.

US stock active mutual funds have generally fared quite badly, underperforming by over 1% annually against passive mutual funds & ETFs. See light orange segment in chart below for US stock active mutual funds.

Meanwhile, for the non-US stock active mutual funds, several categories have shown historical outperformance relative to their passive peers. See the green bars in the blue section below.

Furthermore, for US stock active mutual funds, the cost of picking the wrong manager outweighs the benefit of picking the right one

US stock active mutual funds have generally not provided incremental value for the fees charged. The below chart shows the distribution of US large cap stock funds in terms of their excess return over passive funds/ETFs in the past decade.

The negative skew implies that the cost of picking the wrong manager heavily outweighs the benefit of picking the right one.

Fees matter when choosing an actively managed fund

In addition to the category, the probability of active fund manager outperformance is also affected by how low/high the fund’s Total Expense Ratios are.

We’ll refer to Total Expense Ratios as TER.

Active mutual funds with low TERs were more likely to outperform than those with high TERs.

The below table shows the % of outperforming active mutual funds in the cheapest and most expensive TER quintiles, as well as the percentage point difference between the two.

If we look at ALL mutual funds, the “percentage of outperforming active funds in the cheapest TER quintile” is on average 20 PERCENTAGE POINTS HIGHER than the “percentage of outperforming active funds in the most expensive TER quintile“.

(OPTIONAL) Potential explanation for why active mutual funds outperform in non-US stock categories

For non-US stocks especially in emerging markets, there might be information asymmetry between investors. For the asset manager who is able to carry out the appropriate due diligence and analysis, it might result in a positive payoff in terms of higher returns or better risk management.

For bonds, there are a few reasons why active managers may outperform.

With regard to passive mutual funds and ETFs that track indices, a bond index’s construction methodology might not be optimal. This is because many bond indices are market value weighted, which means a company with more debt will feature more heavily in the index and the corresponding ETF that tracks it. As a bond investor, all things equal, my preference would be to invest in companies that are less indebted.
Active mutual funds have the ability to manage risk proactively. If a bond’s credit fundamentals is deteriorating but still held within the bond index, the ETF will likewise have to keep holding onto the bond. An active manager who sees such risk may sell off the bond preemptively.
Active mutual funds can participate in bond IPOs, which are often underpriced to attract sufficient investor demand. As a bond Index is usually rebalanced only at specific timing intervals, a newly issued bond will not feature on the Index immediately and hence the ETF will likely not be able to participate in underpriced bond IPOs.

Conclusion

In this article, we had summarized broad ideas on which vehicles we feel are appropriate to use for different sub-asset class exposures. However, we did not specify any particular ETFs or mutual funds. We aim to explore that in the upcoming weeks. Stay tuned!

The InvestQuest’s View: For diversified exposures to Global and US stocks, stick with low-cost passive mutual funds or ETFs. For exposure to non-US stocks, emerging markets and corporate bonds, I would suggest a cost-efficient active mutual fund.