How style factor returns affect relative performance
Style benchmarks are a valuable tool for evaluating active funds, as investment style and market capitalization have historically tended to explain a significant part of the variation in equity returns.
The purity hypothesis in portfolio management, however, suggests that active funds often don’t strictly adhere to their assigned style benchmarks. This has direct consequences for relative performance. If a specific style performs relatively well over a given period, the hypothesis suggests that fewer active funds in that style will outperform relative to active funds benchmarked against a less well-performing style.
Growth and value under the microscope
We decided to test whether the relative performance of actively managed equity funds behaved in accordance with the purity hypothesis.
The four years through 2023 provided an ideal opportunity to test the hypothesis. Not only did the relative performance of growth and value differ significantly, but performance leadership also flipped. Growth outperformed value over 2020 and 2021, while value outperformed growth over 2022 and 2023.
Our analysis is based on all actively managed U.S. equity funds assigned by Morningstar, Inc., to one of its nine style boxes.[1],[2],[3] In each two-year period, we computed each fund’s return in excess of its relevant Morningstar style index.
Given investors’ particular interest in the recent past in large-capitalization stocks—especially the Magnificent Seven—we focused only on large-cap value and large-cap growth funds in this first step of our analysis.[4]
Over 2020–2021, the large-cap growth benchmark returned 29% on an annualized basis, handily beating the large-cap value benchmark’s 10%. However, only 40% of active large-cap growth funds beat their style benchmark, while 88% of active large-cap value funds did. This observation supports the purity hypothesis.
When growth beat value, fewer growth funds outperformed
Notes: The bars show the annualized return of each style benchmark over the two-year period. The circles depict the share of funds that outperformed their style benchmark over that period. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Vanguard calculations, based on data from Morningstar, Inc.
Over 2022–2023, the tide shifted. Large-cap value rose 6%, outperforming large-cap growth, which declined 6%. And, as over the first period, the outperforming style had fewer outperforming funds. Only 9% of active large-cap value funds outperformed their style benchmark, compared with 88% of active large-cap growth funds. This also reinforces the purity hypothesis.
When value beat growth, fewer value funds outperformed
Notes: The bars show the annualized return of each style benchmark over the two-year period. The circles depict the share of funds that outperformed their style benchmark over that period. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Vanguard calculations, based on data from Morningstar, Inc.
A broader examination of the patterns in active fund performance
The next step of our analysis explored whether the purity hypothesis holds true across all nine styles and over a longer period.
Given that the purity hypothesis does not specifically refer to value and growth, we should expect a negative relationship between the relative performance of style benchmarks and the share of funds that outperform their style benchmark across all nine style categories. To test this, we plotted the performance rank of the style benchmark for each fund category—with 1 being the worst performer and 9 the best—against the share of funds that outperformed their style benchmark. The chart that follows shows this relationship for 12 two-year periods from 2000 through 2023.
The relationship seems to generally hold. The two dimensions negatively correlate with one another over every period. The dots in the chart—each representing the share of outperforming funds in a given style box—tend to move from the top left, where the share of outperforming funds is high and the style benchmark performance is poor, to the bottom right, where the share of outperforming funds is low and the benchmark performance is strong. The average correlation coefficient for this period is –0.63, confirming the general trend.
The negative relationship holds over time and across investment styles
Notes: The figure displays the relationship between the performance rank of style benchmarks and the share of active funds that outperformed their style benchmark over each given two-year period. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Vanguard calculations, based on data from Morningstar, Inc.
Look beyond an active fund’s assigned style benchmark
The results of our analysis are a reminder that the differences between a fund’s exposure and that of its assigned style benchmark matter when evaluating relative returns.
When an active fund underperforms its style benchmark, it may not directly reflect adverse stock selection by the fund manager. It could simply be that the fund has less exposure to the style that is currently in favor. The opposite is also true: A fund’s outperformance might not necessarily be a result of positive stock selection; it could be that the fund has less exposure to the style that is out of favor.
Understanding these patterns can help investors more fairly attribute the performance of active funds to skillful stock selection or simply to broad market trends.
Authors
Jan-Carl Plagge, Ph.D., Vanguard Head of ESG Research and Senior Quantitative Investment Strategist
Jane Wang, Vanguard Investment Strategy Analyst
James J. Rowley Jr., CFA®, Vanguard Global Head of Investment Implementation Research
Notes:
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[1] Our analysis of active equity funds includes all funds that Morningstar assigned to one of its nine-box styles. Hence, it excludes sector equity funds, international equity funds, and nontraditional equity funds such as long-short funds, equity market funds, and leveraged funds.
[2] Morningstar’s nine style boxes are: large value, large blend, large growth, mid value, mid blend, mid growth, small value, small blend, and small growth.
[3] Returns of active funds are measured in U.S. dollars, net of fees. The returns of Morningstar’s benchmark indexes are measured in USD gross return.
[4] The Magnificent Seven includes Apple, Amazon, Microsoft, Nvidia, and Tesla, which are part of Morningstar’s Large Growth Index.