Here’s Where Active Investing Is Actually Beating Passive

It’s not quite apple-picking season yet, but active managers have had a fruitful year so far. 

Actively managed funds are gaining ground on their passive peers, with about 40% of actively managed mutual and exchange traded funds beating the average return of comparable, asset-weighted passive funds over the past 12 months. This is up 7 percentage points from the same time last year, according to a Morningstar report. Meanwhile, active ETFs’ market share has tripled in the past five years, going from 4% of total US ETF assets in 2021 to 12% of the $14.9 trillion market last year, according to a UMB Financial report. But the success of active strategies sometimes simply depends on the type of the fund, said Brendan McCann, a research analyst for Morningstar. 

“Indexing does really well in a large liquid space, like large-cap stocks, where you have a ton of participants working together, lots of transactions, and so there’s greater price discovery,” said McCann. But smaller or niche markets “tend to be less efficient than large-cap markets, so there’s less price discovery going on, and there’s more opportunity for active managers to actually go in and find mispricing.”

No Cap

Active large-cap funds’ success rate lagged behind other categories, with only 27% outperforming their average passive counterpart. This is likely due to the market’s current concentration in large-cap companies, since active managers typically hold less of the larger stocks than the market does, according to McCann. “While the market on paper may be overconcentrated, that doesn’t stop those larger stocks from continuing to grow,” said McCann. “If you’re underweight the largest portion of the market that does super well, you’re going to underperform.” 

Other categories had greater success over the past year:

• Both small and mid-cap active funds performed nearly 20 percentage points better than the prior year, outpacing passive rivals by 49% and 47%, respectively. 
• Active bond funds had a success rate of 52%, as they generally took more credit risk than their indexed counterparts.
• Active global real estate funds had the highest success rate of any category at 74%, up from 14% in the prior year. 

It Pays to Be Cheap: A third of active funds in the cheapest quintile of their respective categories beat their average passive counterparts, as opposed to only 20% for the most expensive funds. If two funds perform the same before the fee, the fund with the lower fee will obviously win, McCann said. “There’s a lot of funds that outperform the market, but then when you charge fees, they’ll underperform,” he said. “It’s like starting a race with whatever the opposite of a head start is.”