By Matthew J. Bartolini, Head of SPDR Americas Research.

SPDR ETFs: Calculating the high cost of active managers who underperform.

When it comes to active management, underperformance can be costly for investors relying on these strategies to beat the market, with 2018 being the latest example.

Not only did global equity markets post its worst return since 2008, but 37% of active equity managers underperformed their benchmark in 2018.

But just how costly is underperformance? We conducted analysis to answer that question and found at least $300 billion of active equity management is not worth its fees. Here’s a closer look at our findings and what they mean for investors who use active strategies.

Methods for assessing active manager returns

Performance is a key aspect of the active manager due diligence process with many financial analysts judging a manager’s performance by studying period-based returns (3, 5, and 10-year periods). While constructive, these period-based returns don’t show the persistence or the reliability of outperformance by an active manager.

For instance, a manager could have outperformed over a five-year period because of one year of great results masking lower-than-benchmark performance throughout the rest of the period. In this example, there isn’t much consistency to build confidence for the future.

Rolling periods are another method to analyze active performance. They are more informative in showcasing the environment for active management than period-based returns, as one can begin to detect trends. As an example, the chart below shows that within the US large-cap category, only 18% of managers in the last five years have outperformed their benchmark.

That figure may sound low, but it was actually an improvement from 2015 when it was closer to 10%. The “rebound” was due to 2017’s environment of higher return dispersion and lower stock correlation, two trends conducive to active management. Correlations, however, spiked in 2018 amidst an uptick in volatility, leading to weak active manager returns, reversing the rebound witnessed in 2017.

Beyond quantifying the environment for active, analyzing rolling periods may also identify managers who consistently beat the benchmark. Managers who outperform over multiple rolling periods demonstrate persistence in providing above benchmark returns during different market cycles – a desirable trait for investors to seek.

Conversely, analyzing the persistence of underperformance can be just as useful, allowing an investor to determine when it’s time to jump ship. Unfortunately, it’s after billions of fees have been spent on consistent below-benchmark returns.

Source: SPDR ETFs.

Uncovering the cost of active managers who underperform

To identify underperforming managers for our analysis we first needed a baseline, so we looked at period-based underperformance, examining manager returns within key asset classes beyond just large caps over the last five years. This would be the most extreme case of underperformers and “misuse” of one’s fee budget.

The findings? Over the past five years, 77% of managers, on average, across the asset classes examined underperformed their benchmark. This equates to the underperformance of an eye-popping $2.3 trillion of assets.

The average fees charged by those managers were 103 basis points. This translates into nearly $111 billion – or roughly $22.2 billion per year – of cumulative fees paid over the last five years in exchange for lower returns than an index.

Now, to be fair, some of those managers could have beaten the benchmark in one year, providing a boost to portfolios at the time, but then did poorly as the market rewarded positions not in the portfolio as time went on. This underscores the need for further due diligence than just period-based returns. Yet, we needed a starting point to ground ourselves.

We knew there were even worse fee offenders out there because of our belief that persistence is paramount in the performance measurement game. Using Morningstar data, we ran rolling calendar year-over-year screens for manager performance vs. their prospectus benchmark within key asset classes. We ran this for three-year and five-year sequential calendar periods, tracking performance in 2014, 2015, 2016, 2017 and 2018.

Here are the results for our three-year study:

Source: SPDR ETFs.

Key takeaways:

• Across these segments, $356 billion of assets underperformed their benchmark each year over the last three years.
• These funds had an average median expense ratio of 0.97%, equating to $10 billion of cumulative fees paid over the last three years just to underperform every year!
• Large-cap value had the fewest managers underperforming while registering the least level of underperformance. This is not a surprise as the “Purity Hypothesis” has been well documented. This is the notion that active managers are more likely to outperform their benchmark when their desired style is out of favor due to style drift. Or simply put, these value managers may be outperforming due to holding some growth stocks not in the benchmark, as growth once again beat value in 2018, extending its run over the past five and ten years where growth has outpaced value by 4.49% and 2.76% on annualized basis, respectively. But 2019 may be different for value as a style.
• Mid-cap blend funds had the worst median calendar year performance. When these managers missed the benchmark, they missed big.
• In the large-cap blend segment, we saw a marked increase in the number of managers underperforming compared to when we ran this at the end of 2017. In our prior analysis, only 58 large-cap blend managers consistently underperformed. Now, after accounting for a rough 2018 and lopping off 2015’s data, that figure is up to 100, equating to roughly 32% of all large-cap blend managers. That’s a lot of underperformance for over $3 billion in fees.

Below are the results of our five-year study:

Source: SPDR ETFs.

Key Takeaways:

• Across these segments, $157 billion of assets underperformed their benchmark each year over the last five years.
• These funds had a median expense ratio of 0.97%, equating to $8 billion of cumulative fees paid over the last five years just to underperform every year!
• Foreign large blend and diversified EM had the fewest managers underperforming as a percent of total funds. Only 3% of each category underperformed and their magnitude of underperformance was also the least.
• Mid-cap blend funds were once again the worst performers.
• Extending the time horizon improved the metrics for Small Caps, underscoring how certain environments are more conducive for active management.

Was it the fee’s fault?

Active managers will charge higher fees than indexed-based strategies. This begs the question, is the underperformance a result of having a higher hurdle rate? Did the underperforming managers charge egregious fees?

The benchmark doesn’t charge a fee, so a manager must derive outperformance beyond the basis points they charge in order to deliver alpha. What we found was that the managers who consistently underperformed did have higher median expense ratios than the typical active manager across every category, but they were not meaningfully higher. In some cases the difference was only a few basis points which makes the underperformance more about strategy execution than anything else.

Trimming the $10 billion active management bill

Investing is never passive, and blending index-based approaches with active management is a sound philosophy. However, selecting the right active manager or the right market segment in which to be active versus deploying an index-based approach is the larger predicament, and we are here to help.

Our analysis shows:

• Investors performing active management due diligence should not rely solely on periodic-based returns but should use rolling or persistent calendar-based analysis to supplement their analysis.
• The selection of an active manager within style categories must consider the environment and whether the outperformance is being led by style drift and not stock selection.
• Active management, or for that matter Smart Beta, may be better deployed in foreign developed or emerging market equities instead of the more efficient market of US large-cap equities.
• Investors should check the price tag on their mid-cap funds more closely, potentially opting for low fee index-based strategies instead, as the underperformance in actively managed mid-cap exposures can be severe.

Overall, our analysis points toward $350 billion of assets that are being overseen by active managers who may not be living up to the fees charged. Investors would be wise to reconsider any allocation to those strategies as the investment landscape is filled with low-cost, index-based solutions that seek to capture the performance of a market-cap weighted benchmark in these categories.

For investors looking to lower fees and potentially improve performance while cutting the $10 billion active bill paid over the last three years, the SPDR Portfolio ETF suite provides ultra-low-cost exposure to US (both broad and within styles), international developed, and EM equities. It also provides access to key segments of the fixed income market from broad aggregate to tailored corporate and precise duration management tools.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)