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Fidelity: How Big, Cheap and Active Beats Passive

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A basis point here, a basis point there, and pretty soon you’re talking real money.

And, typically, investors seeking to squeeze out basis points are looking to passive index funds as their product of choice.

Enter Fidelity Investments with new research presenting the case that investors would do well to set their gaze instead on large active funds…like those of Fidelity, for example.

In truth, the idea is not a new one. American Funds — another large actively managed fund group — has promoted very similar research reaching the same conclusion.

Investors would be prudent to familiarize themselves with the idea in order to make the appropriate mental adjustments — particularly to the shopworn idea that large active funds are too big to succeed.

The new research by Fidelity chief investment officer Tim Cohen and his investment research colleagues Darby Nielson, Brian Leite and Andy Browder confronts that prejudice at the outset.

It posits that many investors — not knowing how to select a winning active fund — figure that choosing a passive fund that will track a benchmark is a no-brainer way to obtain market performance.

Given the huge trend toward indexing, via mutual funds and ETFs, Fidelity was wise to address this elephant in the room.

Indeed, one might assume that the underlying purpose of its research — besides showing investors the conditions under which active outperforms passive — is to provide an easy and intuitive means for investors to select active funds rather than take that no-brainer path that increasingly leads investors to passive funds.

To that end, the Fidelity analysts go right to the crux of the active vs. passive debate — specifically, to the arena of U.S. large-cap stocks.

That category is widely assumed to be the most fairly priced segment of the efficient market, where it is harder to capture excess return.

In contrast, the authors of the report cite data showing that the average active fund easily outperformed passive funds over the past two decades in the less efficient areas of international large-cap and U.S. small-cap equity funds.

But the aggregate data concerning U.S. large-cap funds shows that active funds underperform their passive cousins on average. So the question, as the research paper formulates it, is:

“Is the ‘average’ active fund noted in general studies of active and passive investing truly relevant to the typical investor? Or would investors be able to narrow down the selection using some basic filters?

And, indeed, like American Funds before it, Fidelity selected two selection criteria it argues are “quite intuitive and straightforward to implement:” namely, low fees and high assets — both easily discoverable by investors.

(American Funds also used two criteria: low fees and manager investment in their own funds, which the company’s portfolio managers are noted for doing.)

By filtering all but the fund companies in the lowest quartile for fees, Fidelity found that average returns in the period from 1992 through 2014 improved for both active and passive U.S. large cap stock funds. The cheapest passive funds improved even more than the cheapest active funds.

Fidelity then looked at its second filter size. Its thesis is that a large fund company has the scale to hire more research analysts and the like and attract the best of the talent pool.

Using AUM as a proxy, Fidelity limited its active manager population to the five biggest fund families (which includes Fidelity) and the top 10% of passive index funds by size, thus restricting its comparison to the biggest of the big funds in accordance with its thesis about scale.

In contrast to the lower fees filter, which favored passive funds, the size filter skewed heavily to the active funds, which generated positive excess returns—5 basis points ahead of the tough-to-beat large-cap equity benchmark.

Fidelity explains active’s advantage under the size filter thusly:

“For passive funds, greater resources alone may not improve the results as dramatically as for active funds, likely because there are fewer resource advantages that can convey a large performance impact when the fund’s goal is to approximate the returns of a benchmark index.”

Rather, all passive funds can do is reduce fees as much as possible to get as close as possible (but, alas not higher than) its benchmark (which, after all, is not a product and thus bears no fees).

As you might have guessed, the Fidelity analysts next apply both screens — huge fund families with lowest quartile fees. The dual filter once again improves returns for both active and passive funds, but in the aggregate helps the active funds more than passive funds.

The former beat the benchmark by 18 basis points whereas the latter hugged the benchmark, coming just three points under for a 21-basis-point advantage to actively managed large-cap funds.

Fidelity’s point: these few basis points — about a fifth of a percent — add up. Were an investor to sock away $5,000 a year for 40 years in one of these best-performing actively managed funds, he would come out $61,000 richer than his friend in the one of its best performing passive-fund counterparts.

A basis point here, a basis point there…

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