ETF Strategist

Can anything save active management?

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Actively managed funds had a stellar year last year. The typical manager in both large and small cap funds outperformed, earning 2 percent and 3 percent more than their benchmarks, even after fees, according to data from San Francisco-based Callan Associates.

Yet, the money still flooded into passive funds. Collectively, meanwhile, actively managed U.S. equity funds lost about $20 billion. Domestic index mutual funds and ETFs had net inflows of over $127 billion.

The fact that passive strategies were the big winner in a year when active managers did so well, begs the question: can anything save active management?

Flow of Funds

Actively managed funds still hold the majority of assets worldwide: a stunning 67 percent. But the movement toward passive, which began in the mid-1970s, seems more inexorable now than ever. In the past 15 years, investors have poured $646 billion into index mutual funds, according to the Investment Company Institute. Most people have embraced the premise that you can make more money over time by matching a benchmark's returns rather than trying to beat it.

There are still cases where active management, which is the practice of picking investments in order to outperform a benchmark, makes sense. In some cases, there may not be a well-developed index for an asset class, and as the number of asset classes investors are interested in grows, that could be a growing issue.

Tim McCarthy, the former president of Charles Schwab Corp., recommends keeping 20 percent to 30 percent of your stocks in actively-managed strategies. In part, that's to cover cases such as investments in emerging markets, where there aren't enough companies to make up a large enough index, which can be a problem if, say, one large company in an emerging market takes a nose dive. McCarthy also suggested that actively managed global bond funds also often outperform their indexes because of the way the indexes are weighted.

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Active Approach Deconstructed

Emotionally speaking, active management may make sense for people who love to pick stocks or funds. But these are fairly narrow cases. The evidence against a typical investor using actively managed funds to build most of her portfolio seems to grow all the time.

Even the latest evidence that active management works theoretically provides lots of counter evidence of the way it doesn't work on behalf of investors. Two researchers at Yale University, Antti Petajisto and Martjin Cremers, released a paper showed that most of the funds that call themselves actively managed are really just high-priced index funds. Here's an example: a mutual fund calls itself actively managed and measures its performance against the S&P 500 actually owns 400 of the companies in the S&P.

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Meanwhile, the fund is still charging you 1 percent in fees—probably more than enough, over time, to wipe out any gain that the fund might be lucky to see in any given year.

"Most funds are (not that active.) Those funds significantly underperform the benchmarks," said Cremers. Insiders have known about this for a long time. Most fund managers are controlled by their fear, not of underperforming, but of underperforming too much, so they stick close their benchmarks. They would rather be mediocre than try to be good, which involves the risk of abject failure.

Active management to come back 2014: Pro
Active management to come back 2014: Pro

"Since the early 1990s, in order not to end up in the fourth quartile in performance, many managers have increasingly just mimicked their index or benchmark," writes McCarthy in his new book The Safe Investor. "They do this because they don't want to risk performing substantially worse than their index and then be fired."

The fact that the industry standards make it possible for everyone who calls themselves actively managed to charge 1 percent or 2 percent means that a manager can embrace mediocrity and still be highly paid.

The flip of the closet indexers, of course, are the funds that are truly actively managed. In somewhat controversial research, Cremers found that those funds that differed from their benchmarks by more than 80 percent had a much better chance of outperforming, and did so by an average of 1 percent, net of fees, over 20 years. (Vanguard has published a white paper that found active share did not make a difference in performance).

Only a handful of mutual funds differ from their benchmarks enough to have a high active share and to be considered by experts to be truly actively managed. Cremers said for large cap funds, only about 12 percent of the assets in retail mutual funds is in funds with an active share above 80 percent, meaning that their assets differ by 80 percent from their benchmark. For small cap funds, about 30 percent of assets in retail mutual funds is in funds with an Active Share above 90 percent, and about 72 percent is in funds with an Active Share above 80 percent.

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Active share may be the most conceptually sound support for active management that has come around in decades. Morningstar has already said it plans to add it to the information it offers about mutual funds.

However, active share also in a way narrows the case for active management. It is just much easier to make money by investing in strategies that aim to keep fees low and match the benchmark than it is to make a good bet on a fund that is truly actively managed, which takes a lot of research.

"I would say that unless you know that a fund is truly active, I would be really hesitant," Cremers said. "If you do have time, and you're interested in digging deeper, there's a lot to learn and I think active share can help."