What happens when actively managed mutual funds hold passive investment?

A longstanding debate exists on whether it is better to invest in actively managed or passively managed funds.  Mutual funds with active management pay a manager to attempt to pick outperforming stocks, time the market, and/or use other skills to try to outperform their benchmark.  However, this style of management is not free. Typical costs are considerably higher than those for other funds that are passively managed, such as index mutual funds and exchange-traded funds (ETFs).  Passive funds simply buy and hold stocks or other securities to try to match the returns of an index, like the S&P 500. 

In a recently published article, Dr. Eli Sherrill, Finance Professor at the College of Business, and his coauthors, Sara Shirley and Jeffrey Stark, discover that between 2004 and 2015 over one-third of actively managed mutual funds hold passively managed ETFs.  It is somewhat surprising that so many actively managed mutual funds would hold passive investments.  The authors investigate the association between holding ETF positions and actively managed mutual fund performance and find that mutual funds with small ETF positions perform similarly to non-ETF-user mutual funds.  On the other hand, mutual funds with large ETF positions underperform by between 0.41% and 1.63% annually, have worse market timing ability, and hold more cash (likely leading to a drag on performance).  They conclude that the practice of actively managed mutual funds holding large ETF positions is often a signal of inferior ability and may be a “red flag” for investors.

This work entitled “Actively managed mutual funds holding passive investments: What do ETF positions tell us about mutual fund ability?” appeared in the Journal of Banking and Finance, 2017, volume 76, 48-64.