Looking for above-average performance?

Lower-cost stock funds from the largest fund shops have produced above-average returns.

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U.S. large-cap stocks sit at the core of many investors’ portfolios, thanks to a history of positive long-term performance. But if you look at the mutual fund industry as a whole, you might think that finding funds that match or beat the performance of the broad market has been a challenge, particularly in the parts of the market that are regarded as the most efficient, including U.S. large-cap stock funds. However, new Fidelity research suggests that doing better than average may not be as hard as some believe.

Fidelity’s research shows that “filtering” for funds with lower fees that are also run by the largest fund companies produced a subset of funds with better-than-average performance, for both active and passive funds. In fact, actively managed funds beat both passive funds and the market index on average, even after fees, according to the analysis, which focused on large-cap U.S. funds from 1992 to 2014. In a recent paper, Fidelity’s Timothy Cohen, chief investment officer, equities, Darby Nielson, managing director of quantitative research, and their team describe the results they saw. Below are some highlights of that research.

Behind the screens

The researchers chose the fee and size filters because they believe these filters are intuitive and straightforward. Had other filters been used, results may have been different. Why do these filters work? Like shopping for anything else, looking at mutual funds may include thinking about price, but may also involve considering what you get for your money.

High fees can eat into returns, making it more difficult for a fund to match or beat the performance of a benchmark. So the research team began by screening for funds in the lowest 25% of reported expense ratios for their fund type (active or passive). They selected this subset of funds each month over more than 20 years and then averaged the one-year returns.

Next, the researchers filtered for size. For active funds, they looked for the mutual fund companies with the most assets. In the fund industry, differences in size can be quite large. As of the end of 2014, the median amount of assets for all fund families was less than $300 million, while the median for the top five fund families was more than $184 billion—more than 600 times bigger.

The assumption was that larger fund companies could use size to their advantage, by committing more resources to research and trading, and the benefits of those resources would be shared across all the companies’ different funds.

As shown in the chart above, the filters worked. Simply filtering for lower expense ratios improved the average performance of the funds selected, but both sets of funds still underperformed the market. Selecting funds from the group of the largest fund families improved the average performance as well, and, here, the actively managed funds outperformed the market, while the passive index funds still lagged.

When both filters were combined, the average performance of the selected actively managed funds outperformed the market by 0.18 percentage points (18 basis points). The average performance of the passive index funds also improved, though it still lagged the market slightly (as one would expect from passive funds). It may not be possible to invest in the portfolio of better-performing funds, but the impact of these simple filters may surprise investors who believe that finding active funds that can outperform their benchmarks is too difficult.

Implications for investors

The next time you are looking for a fund, you may want to consider expenses and resources. But remember, these filters are only a starting point, and some outperforming funds might not fit the pattern. Be sure to consider any investment within an asset mix that makes sense for your situation, and then consider the funds’ objectives, risks, and expenses, and other details.

What’s more, average results never tell the whole story. Not all funds with lower expenses or those that are from the biggest shops will outperform, and some higher-cost or lower-resource funds may, particularly over short time horizons. But the results of our filters suggest that some informed research may be able to identify above-average funds for your portfolio, whether you prefer the index-tracking approach of passive funds or the potential outperformance offered by active management.

Learn more

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General Methodology
Fund selection: Our main analysis focused on all U.S. large-cap, foreign large-cap (“international large-cap”), and U.S. small-cap equity mutual funds tracked by Morningstar between Jan. 1, 1992 and Dec. 31, 2014, including all blend, value, and growth funds within each category and including actively managed and passive index funds. We included funds that did not exist for the entire period (closed or merged funds), to reduce survivorship bias. We eliminated funds identified as passive that were labeled as “enhanced index,” and eliminated funds with tracking error greater than 1% (which are unlikely to be actual passive index strategies despite their identification in the database). For international large-cap funds, we eliminated funds benchmarked to a price index, for greater comparability. See below for benchmark indices included and definitions.

Our analysis began with the entire set of funds for which data was available from Morningstar at any point over the full period: 1940 actively managed mutual funds, and 115 passive index mutual funds. We selected the oldest shareclass for each fund as representative; where more than one shareclass was oldest, we chose the class labeled as “retail.”

For U.S. large-cap equity, average fund counts for each subset of selected funds are as follows: Unfiltered (full set of funds available): active 814, passive 50. Fee filter only: active 216, passive 13. Resources filter only: active 79, passive 5. Both filters applied: active 46, passive 3. Total fund counts in sample over full period: active 1940, passive 115. Total fund counts for international large-cap equity funds: active 397, passive 25; average fund counts for performance calculation: active 213, passive 9. Total fund counts for U.S. small-cap equity funds: active 663, passive 40; average fund counts for performance calculation: active 292, passive 15.

Averaging excess returns: We used Morningstar data on returns from Jan. 1, 1992 through Dec. 31, 2014. We calculated each fund’s excess returns on a one-year rolling basis, relative to each fund’s primary prospectus benchmark and net of reported expense ratio, for each month. We used an equal-weighted average to calculate overall industry one-year returns for each month. (We chose to equal weight the averages in order to represent the average performance of the range of individual funds available to investors, rather than asset weighting, which may introduce bias into the analysis.) For filtered subsets of funds, average excess returns ascribed were the one-year forward rolling returns, calculated monthly. All filtered subsets were rebalanced monthly. If a fund closed or was merged during a one-year rolling period, its returns were recorded for the months that it was in existence, and the weighting of the remaining funds in the subset was increased proportionally for the remainder of the year.

Filters: We used Morningstar data on fund expense ratios to represent fees. The fee filter is rebalanced monthly; over the full period, the average cut-off for lowest quartile of fees was 86 bps for active, 19 bps for passive. The resources filter is rebalanced monthly. The resources filter used a different methodology for active and passive in order to generate comparable selectivity; for passive funds, using the same filter as for active funds produced an average annual excess return of -36 basis points for the filtered subset, while using a filter that selected for the top 10% of passive index funds by AUM (approximating the selectivity of the top five fund family filter for actively managed funds) produced a better average annual excess return of -16 basis points.

Indices: Funds in the study included active and passive funds tracked by Morningstar and benchmarked to the following indices: U.S. large-cap equity (all in USD): Russell 1000; Russell 1000 Growth; Russell 1000 Value; Russell 3000; Russell 3000 Growth; Russell 3000 Value; S&P 500. Foreign (international) large-cap equity (all in USD): MSCI ACWI Ex USA; MSCI ACWI Ex USA Growth; MSCI ACWI Ex USA Value; MSCI EAFE; MSCI EAFE Growth; MSCI EAFE Value; MSCI World Ex USA; MSCI World Ex USA Growth; MSCI World Ex USA Value. U.S. small-cap equity (all in USD): Russell 2000; Russell 2000 Growth; Russell 2000 Value; S&P SmallCap 600.
Index definitions:

MSCI ACWI (All Country World Index) ex USA Index is a market capitalization-weighted index designed to measure the investable equity market performance for global investors of large and mid-cap stocks in developed and emerging markets, excluding the United States.
MSCI ACWI (All Country World Index) ex USA Growth (Value) Index is a market capitalization-weighted index designed to measure the investable equity market performance of growth (value) stocks for global investors of large and mid-cap stocks in developed and emerging markets, excluding the United States.
MSCI EAFE Index is a market capitalization-weighted index that is designed to measure the investable equity market performance for global investors in developed markets, excluding the U.S. & Canada.
MSCI EAFE Growth (Value) Index is a market capitalization-weighted index that is designed to measure the investable equity market performance of growth (value) stocks for global investors in developed markets, excluding the U.S. & Canada.
MSCI World ex USA Index is a market capitalization weighted index that is designed to measure the investable equity market performance for global investors of developed markets, excluding the United States.
MSCI World ex USA Growth (Value) Index is a market capitalization weighted index that is designed to measure the investable equity market performance of growth (value) stocks for global investors of developed markets, excluding the United States.
Russell 1000 Index is a market capitalization-weighted index designed to measure the performance of the large-cap segment of the U.S. equity market.
Russell 1000 Growth Index is a market capitalization-weighted index designed to measure the performance of the large-cap growth segment of the U.S. equity market. It includes those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth rates.
Russell 1000 Value Index is a market capitalization-weighted index designed to measure the performance of the large-cap value segment of the U.S. equity market. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower expected growth rates.
Russell 2000 Index is a market capitalization-weighted index designed to measure the performance of the small-cap segment of the U.S. equity market. It includes approximately 2,000 of the smallest securities in the Russell 3000 Index.
Russell 2000 Growth Index is a market capitalization-weighted index designed to measure the performance of the small-cap growth segment of the U.S. equity market. It includes those Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth rates.
Russell 2000 Value Index is a market capitalization-weighted index designed to measure the performance of the small-cap value segment of the U.S. equity market. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth rates.
Russell 3000 Index is a market capitalization-weighted index designed to measure the performance of the 3,000 largest companies in the U.S. equity market.
Russell 3000 Growth Index is a market capitalization-weighted index designed to measure the performance of the broad growth segment of the U.S. equity market. It includes those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth rates.
Russell 3000 Value Index is a market capitalization-weighted index designed to measure the performance of the broad value segment of the U.S. equity market. It includes those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth rates.
S&P 500 Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
S&P SmallCap 600 Index is a market capitalization-weighted index of 600 small-capitalization stocks.
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