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Study after study confirms it: passive investing strategies, and funds that follow them, beat active management, year after year, cycle after cycle.
But surely this time – the six-week period in late February and early March, when markets convulsed in response to the coronavirus crisis, plunging into a bear market at the fastest rate in history – would prove different, two University of Chicago researchers theorized.
Not exactly. In fact, they find that active managers performed “poorly” during the COVID-19 crisis of early 2020, despite the inefficiencies in the market that thoretically should allow talented money managers to prove their worth, and in contrast to the popular belief that active managers can outperform during downturns, if at no other time. The working paper, from Chicago Booth professors Lubos Pastor and M. Blair Vorsatz, quantifies just how poorly. On the plus side, however, it also analyzes a popular investing tool, finding that Morningstar ratings are a useful guide to fund performance.
Pastor and Vorsatz analyze the ten-week period between February 20 – one day after financial markets peaked – and April 30, 2020, by which time they had “largely rebounded,” in their words. It’s a neat natural experiment, because markets spent about half of that time plunging downward, losing 34%, and the second half recovering, by 30%.
Related: Will mutual funds get a second wind… as ETFs?
During that time, 74.2% of active funds lagged the S&P 500 SPX, +0.41% index, the researchers note – and significantly. On average, the funds underperformed by 5.6% during the ten-week period, which would equate to a difference of 29.1% on an annualized basis.
Active funds also trailed behind benchmarks other than the S&P 500, but by smaller margins: 57.6% of funds underperformed their FTSE/Russell benchmarks and 54.2% of funds underperformed their prospectus benchmarks, the researchers noted.
And when compared to five different factor models, active funds “are significantly negative on average,” Pastor and Vorsatz wrote, ranging from a difference of 7.6% annualized to 29.1% annualized, with anywhere from 60.4% to “a stunning 80.2%,” in their words, of active funds lagging those factor models.
There is a silver lining for investors, however. The researchers found that the fund ratings devised and disseminated by Morningstar predicted fund performance “positively and significantly,” Pastor and Vorsatz wrote. “Five-star funds outperform four-star funds, which outperform three-star funds, etc. Five-star funds significantly outperform one-star funds in terms of cumulative benchmark-adjusted returns.”
For every additional star a fund picks up, performance increases by 5.78% per year, meaning that five-star funds outperform those with just one star by an average of 23%.
What’s the takeaway? Perhaps it’s just as simple as: choose passive funds. But as Pastor and Vorsatz note in their conclusion, the reasons active funds performed so woefully “leaves plenty of room for future research.”
Read next: The ‘ANTs’ came marching: how have active, non-transparent ETFs performed so far?
