Active equity mutual funds are well-known to have underperformed passive benchmarks net of fees (e.g. Fama and French 2010). Even so, the active management industry continues to manage tens of trillions of dollars. The puzzling coexistence of a large underperforming active management industry and an accessible passive management industry raises an important question: why are investors willing to tolerate this underperformance?
Actively managed equity funds were expected to outperform in the downturn...
One popular hypothesis, formulated by Moskowitz (2000) and Glode (2011), is that active funds outperform in market downturns, when investors value performance the most. The COVID-19 crisis is particularly suitable for testing this hypothesis, for two reasons. First, investors surely want to hedge against such an unprecedented output contraction and unemployment surge. In the last two weeks of March alone, ten million workers filed for unemployment benefits, more than the almost nine million workers who lost jobs during the Great Recession. Second, large price dislocations during this crisis provide opportunities for active managers to perform well. For example, the S&P 500 experienced its steepest descent in living memory, losing 34% of its value in the five weeks between 19 February and 23 March 2020, before bouncing back by over 30% in the following five weeks.
... but instead, they underperformed a variety of passive benchmarks
Using daily returns for all US active equity mutual funds, our new paper (Pastor and Vorsatz 2020) finds that active funds underperform their passive benchmarks over the 19 February to 30 April period. The underperformance is particularly strong when measured against the S&P 500, as shown in Figure 1: 74% of active funds underperform the S&P 500, with average underperformance equal to -5.6% over the ten-week period, or -29.1% on an annualised basis. Even when comparing active funds to their fund-specific style benchmarks, we find meaningful underperformance: 58% of funds underperform their FTSE/Russell style benchmarks, with average underperformance equal to -2.1%, or -11% on an annualised basis. We also find robust underperformance against five common factor models, with average annualised alphas ranging from -7.6% to -29.1%. All of the average crisis performance measures we consider are reliably negative. In short, active funds perform poorly during the COVID-19 crisis.
Figure 1 Average fund performance vs. the S&P 500 during the COVID-19 crisis
Morningstar sustainability and star ratings predict crisis performance
While active funds underperform on average, some fare better than others. Two of the strongest performance predictors we uncover are Morningstar’s sustainability rating and past performance, or star, rating. For both types of ratings, Morningstar compares funds within an investment-style peer group. Funds are assigned up to five stars for past risk-adjusted performance and up to five globes for sustainability, where more stars/globes indicate better performance/sustainability.
We find that funds with above-average sustainability (four or five globes) outperform the remaining funds with the same style by 14.2% per year in terms of FTSE/Russell benchmark-adjusted returns. This result is largely driven by environmental sustainability. In addition, five-star funds outperform one-star funds with the same style by 23.1% per year, also benchmark-adjusted.
Our fund-level evidence linking performance to sustainability complements stock-level evidence by Albuquerque et al. (2020) and Ding et al. (2020) that more sustainable stocks perform better under COVID-19. The high returns of sustainable funds and stocks suggest that market participants’ tastes continue shifting toward green assets and green products during this crisis (Pastor et al. 2020).
Sustainability is a necessity, not a luxury good
In addition to fund performance, we analyse capital flows in and out of active equity mutual funds. The COVID-19 crisis enables us to test the hypothesis that sustainability is a ‘luxury good’. Under this hypothesis, interest in sustainability should subside during this major economic and health crisis. In contrast, we find that investors retain their commitment to sustainability under COVID-19. More sustainable funds – particularly those that are more environmentally sustainable and those that employ exclusion criteria in their investment process – receive relatively more net flows than less sustainable funds within the same style group. Figure 2 illustrates these relations, plotting average cumulative net flows by sustainability rating (Panel A) and for funds that do and do not use exclusion criteria in their investment process (Panel B). The fact that more sustainable funds experience net inflows is particularly striking in the context of steady net outflows from active funds in recent years.
Figure 2 Cumulative fund flows and sustainability indicators
Our study contributes to the recent literature on how COVID-19 has affected the economy and financial markets. Multiple studies have sought to quantify the economic repercussions of the spread of COVID-19 (e.g. Boone 2020, McKibbin and Fernando 2020) and the appropriate policy response (e.g. Beck 2020, Gopinath 2020). Other studies have sought to understand how the health crisis affects stock and bond markets (e.g. Ramelli and Wagner 2020, O’Hara and Zhou 2020) and investor expectations (e.g. Gormsen and Koijen 2020, Pagano et al. 2020).
Our results contradict two popular hypotheses. First, they reject the hypothesis that active funds make up for their disappointing average performance by performing well in recessions. Second, they challenge the view that sustainability is a ‘luxury good’. Instead, the fact that investors retain their commitment to sustainability during a major crisis suggests they have come to view sustainability as a necessity.
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