Active Managers Struggle to Beat Index Funds Amid Volatility, Morningstar Finds.

Active funds struggled to beat index funds over the past year, despite market volatility tied to elections and tariffs. Only 33% of active funds had higher asset-weighted returns than their index counterparts, a drop of 14 percentage points from the prior year. Success varies by sector, with index U.S. large-cap stock funds generally beating their actively managed counterparts. However, active managers fare better in less liquid areas of the market, such as fixed income, real estate, and small-cap and emerging-market stocks. Fees are a key consideration for investors.

The past year has seen active funds struggle to outperform index funds, with market volatility due to elections and tariffs playing a significant role. According to Morningstar, only 33% of active funds had higher asset-weighted returns than their index counterparts, a drop of 14 percentage points from the previous year [1]. This trend highlights the challenges active managers face in beating the market, especially in more liquid areas like large-cap stocks.

Index funds, known for their low fees and broad diversification, have become increasingly popular. However, a closer examination reveals hidden costs and limitations that investors should be aware of. A study by Dimensional found that the rigid implementation process of index funds may be costing investors millions of dollars each year [2]. This includes arbitrary construction rules for security inclusion and the impact of index reconstitution on market liquidity.

Index funds often aim to replicate market performance, but each index provider has its own methodology. For instance, the Russell 2000 and CRSP US Small Cap indices, both representing domestic small companies, have less than a third of their weight in common [2]. This discrepancy can lead to significant differences in returns. For example, the average annual difference between the highest and lowest returns of the S&P Small Cap 600, Russell 2000, and CRSP US Small Cap was nearly 5% between 2004 and 2023 [2].

Moreover, index reconstitution, the process of updating the identity and weights of constituents, can impose a performance drag on investor returns. While index funds typically charge low expense ratios, the costs associated with reconstitution, such as increased trading volume, can reduce returns [2]. Dimensional found that trading volumes on reconstitution days were many multiples higher than typical daily trading volumes, leading to higher trading costs [2].

Investors should treat index funds like any other significant investment. Understanding the investable universe, how the index defines the market, and the operational costs associated with index funds is crucial. It's unlikely that one would buy a car without due diligence, and the same should apply to index funds.

While active managers may struggle in liquid markets, they often excel in less liquid areas such as fixed income, real estate, small-cap, and emerging-market stocks. Therefore, investors should consider their risk tolerance and market exposure when choosing between active and passive investment strategies.

References:
[1] https://www.thedailyupside.com/advisor/investing-strategies/index-investors-may-be-losing-millions-of-dollars-each-year-heres-why/
[2] https://www.thedailyupside.com/advisor/investing-strategies/index-investors-may-be-losing-millions-of-dollars-each-year-heres-why/