Stock market mutual funds are failing, and their survival is at stake

Fewer
active funds are successfully beating their
benchmarks.
Scott
Olson/Getty

• Fewer equity mutual funds are succeeding at beating
  their benchmarks, according to Morningstar. 
• They continue to be trounced by passive mutual funds
  and cheaper products designed to track an index. 
• JPMorgan and Vanguard Group this week announced
  products that could put the active-management industry under
  even more strain. 

Stock pickers have one overarching mandate: deliver more returns
than your benchmark index. 

But fewer of them are achieving that, according to Morningstar’s
latest
semiannual report on mutual funds, which dives into how
active funds stack up against their passive peers. 

The success rate — defined as beating a benchmark — among
actively-managed funds this year through June was 36%, down from
43% in 2017. A smaller share of funds found success year-on-year
in fifteen out of 19 categories compiled by Morningstar, with
real-estate funds seeing the most success. 

“Selecting winning active managers is very difficult,” said Ben
Johnson, author of the report and Morningstar’s
director of global ETF and passive strategies research.

“Very few of them survive. Very few of them that wind up
surviving also outperform  their average passive peers over
longer time horizons.” One exception has been active
foreign-stock funds. 

Morningstar studied about 4,500 US funds that manage roughly
$16.1 trillion in assets, representing about 79% of the overall
fund market. 

Goldman Sachs examined the industry and arrived at the same
conclusion: mutual funds are struggling of late.

“The recent underperformance of overweight sectors (financials
and materials) and
stock positions has weighed on fund returns versus their
benchmarks,” David Kostin, Goldman’s head of US equity strategy,
said in a note on Wednesday. 

“A rising equity market and low return dispersion have also
created a less favorable investment landscape for fund
outperformance than in early 2018.” In other words, the tide is
lifting most of the boats, making it harder for stock pickers to
find big winners.

All told, the resurgence and strong outperformance of
stock pickers in 2017 and early 2018 may have been
short-lived.

Morningstar

But beyond active funds’ success rates, which are volatile in the
short term, the boom of cheaper index funds is enduring. 

Morningstar’s scoreboard on mutual funds’ success arrived right
after two major Wall Street firms announced plans that could
further shake up active management.

JPMorgan announced on Tuesday that it will
launch a stock-trading app which offers free trades in some
cases. On the same day, Vanguard, whose founder Jack Bogle is
considered the godfather of index funds, announced it would offer
a free platform for exchange-traded funds. 

This price war has already driven some costs to zero and
continues to tilt in favor of passive funds. 

The chart below puts it into stunning perspective: This year,
equity ETFs and passive mutual funds have earned $193 billion in
inflows, versus $87 billion in outflows from active equity mutual
funds, according to Goldman Sachs. 

“Perhaps the single most reliable metric that investors can use
to their advantage to help improve their odds of picking a
winning active manager is to select from the cheapest active
manager in any given category,” Johnson told Business Insider.

Goldman Sachs

What active funds are buying and selling

To begin with where money is not going, big tech has fallen out
of favor.

The largest tech companies — Facebook, Apple, Amazon, Netflix and
Google-parent Alphabet — led the stock market to new highs last
year and in early 2018. But after the surge returned valuations
to
tech-bubble levels, mutual funds began to pare their bets on
these stocks. 

Also, some tech companies gave investors specific reasons to be
worried. Notably,
Facebook came under fire for how its platform was weaponized
by Cambridge Analytica during the 2016 election and for its
handling of users’ data.  

“The large-growth category has been particularly difficult for
active managers,” Morningstar’s report said.

“Nearly two thirds of the active funds that existed in this
category 15 years ago survived and just 10.2% managed to both
survive and outperform their average passively managed peer.”

This week, fund managers poured $100 million into tech stocks — a
droplet compared to the $22 billion that has flowed in
year-to-date, according to a Bank of America Merrill Lynch
survey. Michael Hartnett, the bank’s chief investment strategist,
said this confirmed that tech’s leadership was slowing. 

Separately, Goldman Sachs parsed second-quarter equity holdings
in 13-F filings and deduced that mutual funds cut their
overweight allocations to financials and tech to the lowest level
in five years.  

To find winners, mutual funds in Q2 increased their holdings of
healthcare stocks relative to Q1 more than any other sector. And
on average, their exposure to bond proxies — telecom, consumer
staples, and utilities — was at a five-year high.  

Bank of America Merrill Lynch