How do U.S. active funds outperform benchmarks?

Introduction: Recently, after the China Securities Regulatory Commission released the "Action Plan for Promoting the High-Quality Development of Public Funds," the provisions regarding the long-term continuous outperformance of benchmarks have attracted market attention. Drawing on the United States, although active equity funds underperform benchmarks as a norm, there are still some products with significant excess returns. Based on the experience of nearly 2,900 products, we summarize the experiences of high win-rate funds in benchmark selection and investment strategies. For details, see the report.

1. Starting with Benchmark Selection

The subsequent statistical sample is based on 2,898 actively managed mutual funds that are still in existence and registered in the United States, as recorded by Lipper Fund.

Active funds linked to the S&P 500 and Russell 1000 Growth, among other "popular" broad-based indices, find it difficult to outperform. In contrast, products based on "niche" indices such as Russell 2000 and Russell 2000 Value perform better. As of April 30, 2025, the proportion of active equity funds using the S&P 500 and Russell 1000 Growth as benchmarks is 18.49% and 3.4%, respectively, with management scale proportions of 24.62% and 6.14%. However, these products do not excel in terms of win rate, excess returns, and α returns. In contrast, although the scale proportions of active funds based on Russell 2000 and Russell 2000 Value are only 1.66% and 1.08%, they are more likely to outperform, with significant excess returns and α.

In terms of win rate, looking at the medium-term 3-year dimension, active funds based on Russell 2000 Value and Russell 2000 indices are more likely to outperform, while products based on Russell 1000 Growth, Russell Mid-Cap Growth, and MSCI Global have a higher probability of underperforming. In the long-term 10-year dimension, the probability of outperforming for MSCI Non-U.S., MSCI Europe, Australia, and Far East, Russell 2000, and Russell 2000 Value exceeds 50%, while the win rate of active funds beating Russell Mid-Cap Value, Russell Mid-Cap Growth, and Russell 1000 Growth is less than 20%. Additionally, as the most well-known index in the U.S. stock market, funds benchmarked against the S&P 500 have a win rate of less than 40% over both the 3-year and 10-year dimensions.

In terms of excess returns, looking at the medium-term 3-year dimension, active funds benchmarked against Russell 2000 Value (1.2%), Russell 2000 (1.0%), and MSCI Emerging Markets (0.2%) have higher excess returns, while those linked to Russell Mid-Cap Growth (-5.7%), MSCI Global (-2.3%), and Russell 2000 Growth (-2.2%) significantly underperform From a long-term 10-year perspective, actively managed funds linked to the Russell 2000 Growth (1.0%) have the highest annualized excess return compared to the benchmark, followed by those based on the Russell 2000 Value (-0.1%) and Russell 1000 Value (-0.2%). In contrast, products based on the Russell 1000 Growth (-8.0%), Russell Midcap Growth (-3.1%), and S&P 500 (-2.7%) significantly underperform.

In terms of α, actively managed equity funds linked to the Russell 2000 and Russell 1000 Value achieve higher α returns in the medium to long term. From a medium-term 3-year perspective, actively managed funds based on the Russell 2000 Value (9.1%), Russell 2000 (6.2%), and MSCI Emerging Markets (0.7%) show more significant α returns, while products linked to Russell Midcap Growth (-31.7%), Russell 2000 Growth (-15.3%), and Russell 1000 Growth (-11.5%) have significantly negative α. From a long-term 10-year perspective, actively managed funds linked to the Russell 2000 Growth (5.2%) have the highest α returns compared to the benchmark, followed by actively managed equity funds based on the Russell 1000 Value (0.9%) and Russell 2000 (0.5%), while products based on the Russell 1000 Growth (-13.3%), Russell Midcap Growth (-8.2%), and S&P 500 (-6.1%) have relatively small α.

II. Strategy: "Go where there are fewer people" can effectively increase win rates

(1) Geographically, funds investing in non-U.S. markets are more likely to outperform.

When categorized by the main investment regions of the products, actively managed equity funds primarily covering Japan and Latin America have a relatively higher win rate against the benchmark. Whether viewed from a medium-term 3-year perspective or a long-term 10-year perspective, the proportion of actively managed funds covering Japan, Latin America, Europe, and emerging markets that outperform the benchmark is significantly higher than that of products primarily investing in the U.S., globally, and globally excluding the U.S.

In terms of excess returns, actively managed equity funds investing in Japan and Latin America outperform the benchmark significantly in both the medium and long term. From a medium-term 3-year perspective, actively managed equity funds investing in Latin America (0.3%) and Japan (0.7%) have the highest annualized excess returns, while products covering the global market (-1.4%) and global markets excluding the U.S. (-1.1%) significantly underperform From a long-term 10-year perspective, actively managed funds focused on investing in Japan (1.0%) have the highest annualized excess returns compared to the benchmark, followed by those investing in Latin America (0.7%) and emerging markets (-0.4%). In contrast, actively managed funds primarily investing in the United States (-1.5%), Asia-Pacific (-1.1%), and global markets (-0.7%) significantly underperform the benchmark.

(2) In terms of style, small-cap and value style funds are more likely to outperform

When categorized by investment style, actively managed funds focusing on small-cap and value styles are more likely to beat the benchmark.

On one hand, from a market capitalization perspective, small-cap style actively managed equity funds have a significantly higher probability of outperforming the benchmark across different short, medium, and long-term time frames, followed by multi-cap style funds, while large-cap and mid-cap actively managed funds have relatively lower win rates.

On the other hand, from a growth/value style perspective, value style actively managed equity products outperform the benchmark at a higher rate than growth style products across different short, medium, and long-term time frames.

In terms of excess returns, small-cap value, multi-cap value, and large-cap value funds have outperformed the benchmark more frequently in the medium and long term. In the medium-term 3-year perspective, small-cap value (1.8%), large-cap value (0.4%), and small-cap balanced (0.2%) products significantly outperform, while mid-cap growth (-5.4%), multi-cap growth (-2.2%), and large-cap growth (-1.5%) funds clearly lag behind the benchmark. In the long-term 10-year perspective, small-cap growth (1.1%) funds have the highest annualized excess returns, followed by small-cap value (0.0%) and large-cap value (-0.3%) actively managed equity funds, while large-cap growth (-4.2%), mid-cap growth (-3.6%), and multi-cap growth (-2.5%) actively managed funds underperform significantly.

(3) Reducing congestion is an important means to enhance the probability of outperforming the benchmark

In summary, non-U.S. markets and non-large-cap growth styles are product characteristics that can beat the benchmark and achieve excess returns.

The underlying reason is that most actively managed funds in the U.S. primarily invest in the U.S. market and large-cap/growth styles, which overlap too much with the main theme of the global market over the past decade (the long bull market of U.S. tech stocks). Therefore, related types of products find it difficult to contribute α returns through timing/sector rotation/stock selection, leading to a compression of the return space and the probability of outperforming the benchmark. ** On one hand, as the leading technology stocks in the US stock market gradually become the strongest global main line, market returns are overly concentrated in a few stocks in the US technology sector, resulting in β far exceeding α. On the other hand, as of April 30, 2025, the scale of actively managed equity fund products focused on the US stock market accounts for over 70% of the total scale of all actively managed equity funds, with large-cap growth funds accounting for over 30%. A large number of professional investment institutions are deeply engaged in leading technology stocks, leading to limited market expectation differences. Therefore, the difficulty for most US actively managed equity funds to select stocks with α attributes has significantly increased over the past decade.

Conversely, actively managed equity funds that invest in non-US markets, small-cap/value styles, and other less crowded directions can leverage their superior investment research capabilities to uncover stocks that are not yet fully priced by the market, thereby capturing returns far exceeding the benchmark. In terms of investment regions, over 3-year and 10-year dimensions, the α of actively managed funds covering non-US markets far exceeds that of products investing in US stocks, with actively managed products investing in Latin America, Japan, and emerging markets showing the most significant α. In terms of investment styles, large-cap value, small-cap value, and small-cap growth styles show more significant α in the medium to long term, while the ability of mid to large-cap growth funds, which have a high number and scale proportion of products, to capture α has continued to be weak over the past decade.

In addition, investing in "less crowded places" can help actively managed funds attract incremental capital, improve the liability side, and thus increase the probability of outperforming the benchmark. Since 2014, with the rapid development of ETFs, another important reason for actively managed equity funds underperforming the benchmark is the continuous redemption pressure. To meet the liquidity demands arising from the deterioration of the liability side, actively managed products may be forced to adjust their positions (increasing the proportion of more liquid and high-quality assets to cope with redemptions) or sell assets at a discount, thereby dragging down their own performance. However, according to our analysis in "Three Ways for US Active Funds to Break the Deadlock: Experience Summary of 2,833 Products (20241204)", benefiting from investors' increased demand for hedging and diversifying risks, combined with the low coverage of ETFs in related fields, products investing in non-US markets, small-cap, and value styles still have a high probability of recording net inflows over the past three years Therefore, investing in low-crowding areas also enhances the probability of outperforming the benchmark by reducing pressure on the liability side.

This article is sourced from: Yao Wang Hou Shi, author: Zhang Qiyao, original title: "How Do Active Funds in the U.S. Beat the Benchmark?"

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