EXECUTIVE SUMMARY
- Modern portfolio theory (MPT) states that expectations of returns must be accompanied by risk or variation around the expected return. It assumes that higher risk should be compensated, on average, by higher returns.
- Beyond relative performance of funds, market participants are also interested in the risks taken to achieve those returns. This motivated us to examine the performance of actively managed funds on a riskadjusted basis.
- Critiques of passive investing often argue that indices are not risk managed, unlike active management. Therefore, our study aims to understand whether actively managed funds are able to generate higher risk-adjusted returns than their corresponding benchmarks.
- We used the standard deviation of monthly returns, over a given period, to define and measure risk. We used net of fees and gross of fees returns in our calculation of risk. Our goal was to establish whether risk or fees affected managers’ relative performance versus the benchmark.
- We used the return/risk ratio to evaluate managers’ risk-adjusted performance. To make our comparison relevant, we also adjusted the returns of the benchmarks used in our analysis by their volatility.
- Our analysis showed that on a risk-adjusted basis, the majority of actively managed domestic and international equity funds underperformed the benchmarks when using net of fees returns. However, when gross of fees returns were used, managers in certain categories outperformed the benchmarks.
- In fixed income, we found that actively managed bond funds outperformed their benchmarks when gross of fees returns were used. The results highlighted that fees negatively affected active bond funds’ performance.
INTRODUCTION
MPT, introduced by Harry Markowitz (1952), Jack Treynor (1962), William Sharpe (1964), and John Lintner (1965), states that the expectation of returns must be accompanied by risk—the variation (or volatility) around the expected return. MPT assumes that higher risk should be compensated, on average, by higher returns.
We applied the same principle to active managers’ performance. Since its launch in 2002, the SPIVA Scorecard has looked at the relative performance of actively managed equity and fixed income funds against their respective benchmarks across different regions. Beyond the relative performance of funds, market participants are also interested in the risks taken to achieve those returns. This motivated us to examine the performance of actively managed funds on a risk-adjusted basis.
Moreover, critiques of passive investing often argue that indices are not risk-managed, unlike active management. Previous research by S&P Dow Jones Indices revealed that active funds typically had higher risk than comparable benchmarks and relative fund volatility tended to be persistent (Edwards et al. 2016).
Therefore, our study seeks to establish whether actively managed funds are able to generate higher risk-adjusted returns than their corresponding benchmarks over a long-term investment horizon.
As with any analysis involving risk-adjusted performance, it is important to define risk and how to measure it. In our analysis, we used the standard deviation of monthly returns over a given period to define and measure risk. The monthly standard deviation was annualized by multiplying it by the square root of 12.
The risk/return ratio looks at the relationship and the trade-off between risk and return. All else equal, a fund with a higher ratio is preferable since it delivers a higher return per unit of risk taken. To make our comparison relevant, we also adjusted the returns of the benchmarks used in our analysis by their volatility.
We acknowledge that there are other measures of risk that may be of interest to market participants, such as the downside variance or Sortino ratio, which may align better with different views on risk. Those ratios are suitable for strategies with positively skewed or negatively skewed returns, such as options-based or CTA strategies (Rollinger and Hoffman 2013). Since our study universe comprised long-only, 40 Act mutual funds, and for purposes of simplicity and comprehensiveness, we chose the Sharpe ratio to represent risk-adjusted returns.
The selection and the appropriateness of benchmarks were highly critical in evaluating risk-adjusted performance. The SPIVA U.S. Scorecard ensures that the benchmarks used in the analysis are determined based on managers’ investment styles. For example, large-cap value funds are compared against the S&P 500® Value, rather than S&P 500. As such, we are confident that the benchmarks used in our study reflect the risk profiles and the characteristics of the corresponding managers’ investments.
