Trends in Active Fund Performance and What to Watch Now

Uneven trends across asset classes marked 2023. Equity volatility was low, and stocks posted gains above 20%,¹ albeit led by just a few firms. But bond volatility was elevated and returns were dispersed — with core bonds nearly incurring losses while credit was rewarded with double-digit gains.²

Active performance was also mixed. Active equity funds had their lowest hit rate (percent of funds outperforming) in seven years, while active bond strategies posted their second-best performance in ten years.

So how did 2023’s trends compare to history? And what might 2024 bring? Here’s what to watch for now.

Active Short-Term Bond Funds’ Best Hit Rate in Ten Years

Roughly 48% of active bond managers beat their benchmark in 2023, well above the historical average of 37%.³ Among the hit rate standouts:

• 76% of short-term bond funds, their best performance since 2012, second-best in the past 20 years, and well above their 20-year average of 49%⁴
• 68% of US intermediate core-plus and 57% of US intermediate core funds, far above their respective 20-year averages of 54% and 42%⁵
• 61% of ultra-short bond funds, a six-year best and better than their 20-year average of 48%⁶
• 56% of US corporate bond funds, versus a 20-year average of 45%, and the fourth time in five years that active corporate bond managers have had a better than average hit rate⁷

Active high yield lagged. The high yield beta rally at the end of year dented some of the credit selection alpha from earlier in the year. As a result, just 26% of funds beat their benchmark, down from 42% at the end of Q3.⁸

Active Bond Funds See Above Average Alpha

Last year, active bond funds beat their benchmark with an average excess return of +0.30% versus a 20-year average of -0.16%.⁹ That’s not surprising considering that volatility, value, and return dispersion drive alpha and market inefficiencies — and 2023 bond markets had all three:

• Credit rebounded from a weak 2022 with double-digit gains,¹⁰ and many core and core-plus managers looked to traditional and non-traditional credit sectors to generate out-of-benchmark alpha.
• Realized volatility on the Agg hovered in the top decile for most of 2023,¹¹ adding to the dispersion of returns and more potential alpha opportunities.
• Yields reached 15-year highs,¹² creating value opportunities for enterprising managers to employ security selection skill and harness mispricings.

Excess returns for ultra-short and short-term funds were far greater than their 20-year average,¹³ as high short-term rates and elevated rate volatility allowed for more nimble positioning along the curve, relative to inflexible benchmarks.

Increased volatility, high rates, and wide dispersion of returns favored managers with broader remits. Intermediate-core and core-plus funds produced positive excess returns higher than their long-term averages. The same was true for even more flexible mandates; multi-sector and non-traditional bond funds had the strongest excess returns overall and stronger alpha relative to history.¹⁴

Active Equity Funds’ Hit Rates and Alpha Falter

Just four equity categories had better-than-average hit rates in 2023 (Figure 3). And only two small-cap categories had better-than-average rates of 50% or greater:

• 55% of US small value funds¹⁵
• 50% of US small blend funds¹⁶

In fact, the weakness in equity funds’ outperformance was stark:

• 20% of global large blend funds¹⁷
• 20% of US large blend funds, down from 54% in 2022¹⁸
• 31% of US mid-cap funds, their lowest rate in seven years¹⁹
• 31% of US large value funds, down from 72% in 2022²⁰

In a year where pairwise correlations were near long-term averages — indicating 2023 was not a clear stock-pickers’ market²¹ — equity volatility remained low and market leadership was narrow. So, it’s no surprise that most active US equity funds (as well as global funds with a heavy US allocation) underperformed their benchmarks and historical average hit rates.

Non-US equity funds had better results, indicating more abundant alpha opportunities in markets with more return dispersion. Notably, 48% of emerging market managers outperformed their benchmarks, above the 20-year average for the fourth time in five years.²²

The four markets with better than average hit rates — emerging markets, US large growth, US small blend, US small value — also had better-than-average positive excess returns.²³

The 49% of US large growth funds that outperformed, the category with the largest differential to their historical average excess return (39%), indicates significant outliers to the upside in a growth-led, AI-frenzied market.²⁴ A style reversal in 2024 could negatively impact the outliers that rode the hot dot in 2023.

What to Watch in 2024

To assess active bond funds’ potential in 2024 to repeat last year’s trends, watch the macro headlines. This year, the Federal Reserve (Fed) is expected to begin cutting rates, ideally without harming markets or the economy. This transition from hiking to holding to cutting will likely continue to stoke rate volatility and realized risks throughout the curve.

Alongside unconstructive valuations (spreads are 30% below 20-year averages)²⁵ and uneven fundamental trends for credit, the backdrop for potential alpha generation appears conducive once again in 2024.

For equity managers, keep an eye on breadth. Last year, only a third of stocks beat the index in 2023 as returns were concentrated.²⁶ So, if there are more star stocks to overweight in 2024, that moderation in the concentration of market power could reverse active equity managers’ fortunes. If not, it could be another dismal year for some managers.

Shifts in the market and the economy in 2024 will likely present new opportunities for investors — ones that could continue to drive assets into the more than 1,300 active ETFs that appeal to investors for their precision, low cost, and tax efficiency relative to mutual funds.²⁷

Notably, the average expense ratio of active ETFs is 0.58%, compared to 0.85% for active mutual funds. And just 5% of active ETFs paid capital gains dividends in 2023, compared to 34% for active mutual funds.²⁸

Those traits helped active ETFs attract a record $132 billion in 2023²⁹ — eclipsing 2022's record of $106 billion — while active mutual funds saw more than $500 billion of outflows in 2023.³⁰ You’re likely to see ETFs, not mutual funds, once again be the investment vehicle of choice for the implementation of active strategies in 2024.

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