Where Active Fund Investors Were Flocking to & Fleeing From in 2016

We all have heard about the ongoing industry shift from Active to Passive Funds as illustrated below via Morningstar

However, despite Active funds as a whole being in net redemptions...there are still net winners and losers. Below I have highlighted the Active Mutual Funds within the largest 15 Morningstar categories with the most net inflow and most net outflows in 2016.

While this does tell you investor preference for 2016.....it also might just highlight investor short-termism. While some may have been due to legit concerns about a recent manager departure (Virtus Emerging Markets Opp and Pimco Total Return come to mind). A lot could have simply had to do with bad performance the year before in 2015. In fact, of those listed with the most outflows....11 of the 15 lost to their benchmark in 2015.

However, it seems investors may be overly focused on shorter term returns, because heading into 2016 12 of those 15 funds with the most outflows had records of 10yrs or more.....and 9 of those 12 beat their benchmarks over that timeframe. While each situation is unique, history says investors shouldn't be given the benefit of the doubt....they historically make bad timing decisions when it comes to hiring or firing managers.

How The Largest Actively Managed Mutual Funds From 15 years Ago Performed

You can't go long without reading an article about the death of active management. Somewhere in a discussion like that you will also hear that the larger a fund gets the more likely it is to under-perform. My purpose of this post is not to get into either of those issues but I thought it would be interesting to take a glimpse back in time to the largest funds of 1999 (15 years ago).

For this exercise I decided to screen for the largest actively managed funds 15 years ago (8/1999) which had the S&P 500 as their prospectus benchmark. The top 10 results looked like this

So how did they do? Were they too big to outperform?

Indeed, the largest fund did manage to under-perform. However, as a whole, these large funds did quite well. Over the last 15 years the largest 10 funds which were benchmarked to the S&P 500 managed to return an average of 5.47% compared to 4.47% for the S&P 500.

What's also interesting is that despite the fact that I compared them all to their prospectus benchmark of the S&P 500, a few of them tend to have a known growth tilt (Vanguard Primecap, Growth Fund of America, Fidelty Contrafund) but they all managed to significantly beat the S&P 500 despite the fact that growth significantly underperformed the S&P during this time (Russell 1000 Growth returned only 3.18% compared to 4.47% on the S&P 500).

Are Index Investors Unknowingly Increasing Interest Rate Risk?

Here in an interestingly look at the Barclay's US Aggregate Bond Index from Lord Abbett  The below Chart shows how the duration of the Index has changed over the last ten years.

As you can see, up until late 2010 the duration of the Aggregate Bond Index tended to hover around 4.5 years. That has increased to approximately 5.5 years today. I think it is important that "passive" index investors be aware that they are currently making an "active" decision to increase their interest rate risk.

Morningstar Continues Rollout of Analyst Mutual Fund Ratings, Only 7% Negative.

Morningstar has been rolling out it's new "forward looking" analyst ratings for mutual funds since last November as I have touched on before. The number of funds rated has gone from 349 funds to 924 as of the end of the 2nd quarter (You can see the full list as of 6/30/12 here). While it has been good to see the distribution of ratings even out somewhat, Morningstar still appears to have an allergic reaction to rating funds "negative" as can be seen below.

As a reminder about the meaning of the ratings, per Morningstar....

"The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

After reading that you might assume that anything rated gold, silver or bronze is a fund Morningstar analysts think will provide risk-adjusted outperformance compared to a relevant benchmark over a full market cycle of atleast 5 years. Apparently not......as can be seen by the majority of ratings given to 29 index funds. Obviously you could not expect an index fund to outperform it's relevant benchmark....after all, index funds are designed to REPLICATE their relevant benchmark. So they should generally perform in line with the benchmark, minus fees. The best an index fund can hope to do is meet Morningstar's definition of neutral "Fund that isn’t likely to deliver standout returns, but also isn’t likely to significantly underperform".

Despite the fact that by their very nature index funds can't be expected to outperform their relevant benchmark, of the 29 index funds Morningstar rated, the ratings breakdown as follows: 14 Gold, 9 Silver, 3 Bronze, 2 Neutral, 1 Negative. It is true that the majority of actively managed mutual funds underperform their benchmarks as can be seen below (you can see more in S&P's Indicies vs Active Report). However, the reality is index funds always underperform their benchmarks! (unless a sampling error works in their favor).

However, what Morningstar should take away from the above info is not that index funds deserve metal ratings, what they should take away is that they need to be much more stingy in giving away Gold, Silver & Bronze....because the majority of mutual funds, ACTIVE & PASSIVE, underperform their benchmarks! If everyone knew that metal ratings only meant they would perform like their benchmark I doubt anyone would care for that information, yet Morningstar thinks that is exactly what they should do.