Print
E-MailLubos Pastor is Charles P. McQuaid Professor of Finance at the University of Chicago Booth School of Business and Blair Vorsatz is a PhD student at the University of Chicago Booth School of Business. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here) and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Robert H. Sitkoff and Max M. Schanzenbach (discussed on the Forum here).
Active equity mutual funds are well known to have underperformed passive benchmarks net of fees. Even so, the active management industry continues to manage tens of trillions of dollars. The puzzling coexistence of a large underperforming active management industry and an accessible passive management industry raises an important question: why are investors willing to tolerate this underperformance?
One popular hypothesis is that active funds outperform in market downturns, when investors value performance the most. The COVID-19 crisis is particularly suitable for testing this hypothesis, for two reasons. First, investors surely want to hedge against such an unprecedented output contraction and unemployment surge. Second, large price dislocations during this crisis provide opportunities for active managers to perform well. For example, the S&P 500 experienced its steepest descent in living memory, losing 34% of its value in the five weeks between February 19 and March 23 before bouncing back by over 30% in the following five weeks through the end of April.
Using daily returns for all U.S. active equity mutual funds, we find that active funds underperform their passive benchmarks over the February 19 to April 30 period. The underperformance is particularly strong when measured against the S&P 500. 74% of active funds underperform the S&P 500, with average underperformance equal to -5.6% over the ten-week period, or -29.1% on an annualized basis. Even comparing active funds to their fund-specific style benchmarks, we still document meaningful—albeit smaller—underperformance. 58% of funds underperform their FTSE/Russell style benchmarks, with average underperformance equal to -2.1%, or -11% on an annualized basis. We also find robust underperformance when funds are assessed against five different factor models. In short, active funds perform poorly during the COVID-19 crisis.
Our evidence that active funds underperform runs contrary to findings from prior studies, which document outperformance in recessions. However, those studies examine recessions that are substantially milder than the COVID-19 crisis.
While active funds underperform on average, some fare better than others. Two of the strongest performance predictors we uncover are Morningstar’s sustainability and past performance ratings. For both types of ratings, Morningstar compares funds within an investment style peer group. Funds are then ranked and assigned up to five stars for past risk-adjusted performance and up to five globes for sustainability, where more stars/globes corresponds to better performance/sustainability. Funds with above average sustainability (4 or 5 globes) outperform the remaining funds in the same peer group by 14.2% per year in terms of FTSE/Russell benchmark-adjusted returns. Funds with a high past performance rating (5 stars) outperform funds in the same peer group with a low past performance rating (1 star) by 23.1% per year in terms of FTSE/Russell benchmark-adjusted returns.
In addition to fund performance, we analyze capital flows in and out of active equity mutual funds. The COVID-19 crisis enables us to test a second hypothesis that sustainability is a “luxury good,” in which case interest in sustainability should subside during this major economic and health crisis. In contrast, we find that investors retain their commitment to sustainability during the crisis. More sustainable funds—particularly funds that are more environmentally sustainable and funds that employ exclusion criteria in their investment process—receive relatively more net flows than less sustainable funds within the same peer group.
Our study contributes to the debate on why active management remains popular despite its poor track record. Our results reject the popular hypothesis that active funds make up for their disappointing average performance by performing well in recessions. Our results also contradict the perspective that sustainability is a “luxury good.” Instead, the fact that investors retain their commitment to sustainability during a major crisis suggests they have come to view sustainability as a necessity.
The complete paper is available here.
