FCOM - Actively Managed Equity Funds Vs. ETFs: The Conclusion Is Inconclusive

Summary

• A comparison of funds results in inconsistent outcomes.
• Investment sectors impacted fund comparisons.
• Do not lose sight of a fund manager's declared mission.

From science and mathematics, I learned that a hypothesis is often posed as a question. What follows is research and experiment. The goal is to prove the hypothesis either true or false. The result, learning. Thus, I have a question. Are actively managed equity funds better than ETFs?

There are two opposing arguments regarding investing in actively managed funds. One argument is that actively managed funds rarely beat straight-forward index funds. The second argument is that, especially in volatile times, a good fund manager can make a significant difference in investment performance.

I look to Cathy Wood of ARK Investments as an extreme example of how a fund manager can unduly influence an investment ecosystem. For the past few years, Ms. Wood has had a great deal of media coverage as her firm catered to "long-term growth" investors who embraced the potential of "disruptive innovation". The highs and lows of ARK Investments are inextricably linked to Ms. Wood's and her team's investment decisions, decisions that embraced disruptive innovation as a path to excellent investment returns.

At one time, it seemed that a day would not pass without the media discussing the performance of the ARK Innovation ETF ( ARKK ) and the relative genius of ARKK's leadership. Now, ARKK is rarely discussed, not even as an object lesson of what not to do. As of 12/31/2022, ARKK has had a 1-year NAV return of -66.97%, a 3-year return of -13.83% and a 5-year return of -2.13%. It has significantly underperformed its benchmark index (S&P 500 TR USD) which has had a 5-year return of 9.42%.

Like crypto, meme stocks, and SPACs, ARKK became a darling of a faction of the investment community that promised a quick rabbit's journey to a hefty bank account. This approach is antithetical to the conservative, tortoise approach that I suggest, especially for those who have achieved sufficient wealth to enjoy a comfortable (self-defined) retirement and are seeking to protect their wealth and supplement their income.

Ms. Wood aside, the question still remains whether an actively managed fund is advantageous. The year 2022 was volatile and destructive to wealth. Thus, it seems like a good place to determine the impact of active management. To illustrate, I compared sector ETFs to comparable actively managed mutual funds. For simplicity's sake, I focused the analysis on Fidelity Investment ETFs and mutual funds. The results, documented in the chart below, were inconclusive.

The delta between the comparable ETFs and mutual funds ranged from a low of .10% to a high of 7.35%. I included Morningstar ratings as an objective rating of peer funds. Even in those rating comparisons, exceptions were to be found. For example, Fidelity Select Consumer Staples Portfolio ( FDFAX ) with a 3-star rating outperformed the Fidelity MSCI Consumer Staples ETF ( FSTA ) with a 4-star rating. Mutual fund performance lagged in Health Care and Technology while it out-performed in Financial Services and Utilities.

If there is a pattern, in may be within the sector itself. The greater the risk, the higher probability of divergence. Compared to sub-sectors Health Care Services and Medical Technology and Devices, Health Care also includes more volatile sub-sectors such as Pharmaceuticals and Biotechnology. A fund manager, who is trying to beat their benchmark, may have a larger pool of riskier assets to choose from, and may make bets on specifics stocks that diverge from a weighted index. One year such a bet may falter, and in another year, succeed.

This is pure speculation on my part. And that may just be my point. I happen to own three sector equity mutual funds, two of which have comparable ETFs in this analysis: Fidelity Select Consumer Staples Portfolio and Fidelity Select Utilities Portfolio ( FSUTX ). Even with higher expenses, both outperformed their comparable ETFs. My conclusion? I just happened to have a good year in that regard.

There are other reasons to consider one form of investment over another and I am certain a quick search will result in multiple articles discussing the pros and cons between ETFs and mutual funds in terms of distributions, tax strategy, transaction management, etc.

Finally, I would be remiss to not also mention that a new product - actively managed ETFs - are now being offered by some investment firms. They stride to outperform passive ETFs while providing the flexibility of intraday trading and potential tax efficiency. There are negative aspects, such as higher trading costs, less information regarding the portfolio's holdings, and price efficiency. Where they seek to blend the best of mutual funds and ETFs, they might also blend the worse. Let the buyer beware.

For further details see: