Disillusioned with the performance in active funds, investors are now relying on passive, beta-index exchange traded funds to capture market returns.
Morningstar analyst Michael Rawson argues that common sources of return actually explains the outperformance once attributed to skill in active management.
“Old-fashioned market beta provides the bulk of return–hence, our conclusion that investors should be perfectly content with a fund that provides nothing but beta,” Rawson writes for Morningstar. “It is clear that beta provides the majority of return, even among funds that manage to capture significant alpha.”
Looking at historical data in a capital asset pricing model, or single-factor model, the average monthly return for passive funds was 1.01%, with 0.97 percentage points of the monthly return attributed to market beta and just 0.04 percentage points attributed to alpha, or outperformance.
Meanwhile, in a multi-factor model, alpha for passive funds came in at a negative 0.01 percentage points, which suggests that all the return was provided by exposure to beta factors.
The analyst’s findings show that actively managed funds have generated most of their returns through low-volatile, beta investments. Consequently, most high-risk picks that are intended to generate alpha leave little or no effect on the overall performance of the fund portfolios.
Additionally, Rawson points out that the 99% R-squared for passive funds reveals that most of the movement in passive funds can be explained by the underlying indexing methodology. R-squared is a statistical measure that represents the percentage of a fund or security’s movements relative to a benchmark index – a 100 reading shows that a security perfectly reflects the underlying index. The analyst hints that some active funds may be closet index funds due to their low tracking errors, compared to benchmark indices.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.