By Matthew Bartolini, head of SPDR Americas research at SSGA.

Matthew Bartolini, head of SPDR Americas research at SSGA.

When it comes to active management, underperformance can be costly for investors relying on these strategies to beat the market. But just how costly is underperformance? We conducted an 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.

A better method 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 (three-, five- and ten-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 may paint a different picture, identifying managers who consistently beat the benchmark. Managers who outperform over multiple rolling periods demonstrate persistence, a desirable trait for investors to seek. Rolling periods are also helpful in showcasing the environment for active management. As an example, the chart below shows that within the large-cap category, only 27% 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 dispersion and lower correlation, two trends conducive to active management. But the 27% figure could be challenged in 2018 as dispersion craters and correlation spikes with the return of market volatility.

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 over the last five years. This would be the most extreme case of underperformers.

The findings? Over the past five years, 70% of managers, on average, across the asset classes examined underperformed their benchmark. This equates to the underperformance of an eye-popping $2.9 trillion of assets. The average fees charged by those managers were 100 basis points. This translates into nearly $150 billion—or roughly $29.5 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 they 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 2013, 2014, 2015, 2016 and 2017.

Here are the results for our three-year study:

Source: SPDR ETFs.

Key takeaways:

• Across these segments, $300 billion of assets underperformed their benchmark each year over the last three years.
• These funds had a median expense ratio of 110 basis points, equating to $9 billion of cumulative fees paid over the last three years, just to underperform every year!
• Small-cap blend and diversified emerging markets (EM) had the fewest managers underperforming as a percent of total funds, indicating active management may be most usefully deployed in these markets.
• Mid-cap blend funds charged the most just to underperform
• In the large-cap segment, large-cap growth managers had the worst median underperformance figure. When these managers missed the benchmark, they missed big.

Below are the results of our five-year study:

Source: SPDR ETFs.

Key Takeaways:

• Across these segments, $113 billion of assets underperformed their benchmark each year over the last five years.
• These funds had a median expense ratio of 113 basis points, equating to $6 billion of cumulative fees paid over the last five years just to underperform every year!
• Small-cap blend and diversified EM had the fewest managers underperforming as a percent of total funds. Only 3% of EM funds underperformed and none did within the small cap blend category.
• Mid-cap blend funds were once again the highest fee underperformers
• Although EM managers fared the best as a group, when these managers missed, they missed big, notching an 11.42% median underperformance. This underscores the importance of selecting the right manager even if the segment is “ripe” for alpha.

Trimming the $9 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 vs. 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.
• Active management may be better deployed in US small caps 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 strategies more closely
• The selection of an active manager within the US small cap and EM equity market segments is an important consideration given the size of median underperformance in those categories.

Overall, our analysis points toward $300 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 alternatives 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 $9 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.)