The National Bureau of Economic Research

Are active fund managers working harder for us through the pandemic?  Not according to an analysis of mutual fund returns and flows. It seems that what has served investors well is being in funds investing in  equities that show “sustainability” – what ordinary people think of as responsible investment.

In a paper published this July, Lubos Pastor and Blair Vorsatz  present a comprehensive analysis of the performance and flows of U.S. actively-managed equity mutual funds during the COVID-19 crisis of 2020.

They find that most active funds  have underperformed passive benchmarks during the crisis, contradicting a popular hypothesis. Funds with high sustainability ratings perform well, as do funds with high star ratings. Fund outflows largely extend pre-crisis trends.

Investors prefer funds that apply screening  and funds with high sustainability ratings, especially environmental ones.

they find that investors remain focused on sustainability during this major crisis suggests they view sustainability as a necessity rather than a luxury good.

Contradicting a popular hypothesis

The authors are surprised that the active fund management industry despite its long-lasting underperformance, remains large, managing tens of trillions of dollars. They are puzzled as an alternative—passive funds—is easily available to investors.

The paper explores a popular hypothesis that investors are willing to tolerate underperformance in a time of “normality”  because active funds outperform in periods that are particularly important to investors.

News that American actively managed mutual funds have under performed in the time of the pandemic will come as a shock to those who believe that active fund management is an insurance or hedge against recession.

Relentlessly the paper tests each of the arguments put forward by the fund management industry in support of itself. COVID-19, the paper argues, presents a perfect opportunity for active managers to prove their worth.

It has led to an unprecedented output contraction and the fastest increase in
unemployment on record. Investors surely want to hedge against such a severe crisis

Under the hypothesis that active funds outperform during recessions,they should find it particularly easy to outperform when markets are rife with mispricing.

What actually happened.

Choosing to analyse the ten week period between February 19th (the first day of falls and April 30th , the quarter end) , Pastor and Vorsatz find that the underperformance of active equity funds is particularly strong when measured relative to the S&P 500 benchmark.

They find that 74.2% of active funds—about three quarters!— underperform the S&P 500 during the COVID-19 crisis. The average fund underperformance is −5.6%  during the ten-week period, or −29.1% on an annualized basis.

The paper goes on to explore performance against other benchmarks and factor adjusted returns and finds the same thing. Despite all the conditions being in place for active managers to show their worth, they have underpeformed.

Where investors were protected over the period was through investment in sustainables. It looks at Mornngstar’s “sustainalytics” which rewards responsible investment with a high number of gloves

High-globe funds (those with four or five globes) significantly outperform the remaining funds within the same investment style by 14.2% per year in terms of FTSE/Russell benchmark-adjusted returns. This result is driven largely by environmental sustainability—funds with higher environmental ratings outperform those with lower ratings

The impeccable behaviour of investors.

In their analysis  Pastor and Vorsatz look at behavioral traits to explain why so much money remains in active equity funds concluding that the weight of advertising and information put into the market by those with an interest in highly traded funds has been influential.

It also explores a widely held view that ESG managed funds are “luxury items” that may outperform in good times but are found out when a recession arrives.

The paper accepts that a ten week period is too short to draw conclusions for all time but concludes that investors may be rather less cynical than some managers supposed, Investors did not dash for cash and net outflows from active funds were only just above 1%.

This  perspective predicts that interest in sustainability should subside during a major economic and health crisis. In contrast, we find that investors retain their commitment to sustainability during the COVID-19 crisis. The research found that sustainable funds actually received net inflows over the period

This finding suggests that investors have come to view sustainability as a necessity rather than a luxury good

If investors are taking a long term view on sustainability,  it may be time for active fund managers and marketeers  to change their behavior too,

Is this the end of the line for active managers?

Pastor and Vorsatz are clear about the limitations of their study. It is time limited and does not take into account much of the data that would be needed to analyse the sources of out and under performance (stock selection v market timing).  It accepts that 2020 nor the pandemic is over yet.

The research did validate research by Morningstar into funds with high risk adjusted returns (Morningstar stars) , these funds continued to do well through the crisis period, which suggests that there were pockets of active management which did provide protection

This is not the end of the story and we should not be selling out of active and buying into sustainable ETFs because of this study

But once again, the claims that active managers as a class protect us in times of trouble have proved false.  Each time active managers fail to deliver, the arguments for a passive approach become more compelling.

It appears that investors did not panic in the crisis. Active funds as a whole saw net outflows of about 1.3% over the period but much of this was to passive equivalents. Sustainable funds actually saw net inflows over the period.

It may be that investors are a wiser crowd than many fund active managers supposed!

Thanks to Richard Taylor for sending me this report.

Source – Goldman Sachs