Where Does Active Management Fare Best?
by John Rekenthaler | 08-02-16

To Index or Not
Almost every mutual fund Morningstar Category offers the choice of actively or passively managed funds. Presumably, some categories are better suited for active management than others. What's an investor to do? Where should active funds be used, and where should they not?

Many articles have attempted to answer those questions. Some are based on intuition: "Index in Category A because its marketplace is efficient, but consider investing actively in Category B because its sector is less efficient." Those claims can be discarded. Instinct may work for affairs of the heart, but it is of no use for investing.

Articles that rely on evidence, by running the numbers, would seem to be on firmer ground. However, with this particular topic, the data rest on sand.

Good in Theory
Here is why.

The natural approach when running the numbers is to sort fund categories by their funds' success ratios. That is, for a given time period, calculate what percentage of each category's funds beat a relevant investment index (for example, small-value funds would be compared with a small-value index). Consider investing actively in categories that have high success ratios--say, exceeding 60%. Conversely, the prudent course is to index in categories that have low success ratios.

That sounds sensible. Unfortunately, there is a very large catch, because a category's success ratio depends upon another factor. The ratio is affected by relative performance--that is, by how the category's total returns during the study's time period compare with the returns of other, related categories. Strong category performance hurts active management's score, while weak category performance helps active management.

I will restate the matter more simply. By definition, indexes are 100% devoted to their investment categories. They don't have cash, and they don't hold securities from other investment styles. They offer the pure category experience. Thus, when an investment category leads the performance charts, the index funds typically outdo their more-diluted actively managed rivals. And vice versa.

1,000 Words
A picture will be clearer yet. The chart below shows the nine diversified U.S.-stock fund categories (that is, the nine Morningstar Style Box squares) for various rolling five-year periods. The Y-axis measures that category's success ratio, ranging from less than 10% for the worst results for active management (yikes!) to near 80% for the best. The X-axis shows the category's relative performance. As is customary with X-axes, the weakest numbers are plotted on the left, the strongest on the right.

(If your memories of college statistics have grown fuzzy, z-scores are nothing fancy. They are merely a way of standardizing results, so we can fairly compare performances from volatile time periods to those of stable periods.)

- Source: Morningstar Analysts

The best way to interpret the chart is to consider its four corners.

The top left represents categories that had terrible relative performance and excellent results from active managers. Those who owned a fund from that category, during that particular time period, would be likely be disappointed. The fund was a member of a lagging group--the worst sector of the U.S. stock market. But there was a silver lining for those who held an actively run fund, as it likely outperformed the index.

The bottom right corner represents the flip side of that situation. Those categories pleased their owners by turning in outstanding relative performance. However, the shareholders were not entirely pleased if they owned an actively managed fund, because such funds trailed their indexes. Those investors were in the right place, but they had the wrong type of fund. Better they had indexed.

There are dozens of points near each of those two corners. Good news/bad news is a common outcome.

The other two corners depict not mixed news, but rather the little girl with the curl. When things are good, they are very, very good. And when things are bad, they are horrid. The upper right corner is happiest of times: the category leading in relative performance while its active managers best the indexes. Win-win. The bottom left corner, on the other hand, shows critical failure. The category flopped, as did active managers.

But there are no points landing near those two corners.

The Mirage
The moral of the tale: Active managers appear to be more skilled when their investment universe performs relatively poorly, and less skilled in the reverse case. But that appearance deceives. Manager skill is stable; it is the measurement that wavers. Because manager-versus-index results are linked to relative-performance results, the time period selected will largely determine the outcome.

In other words, active management can be said to be a sound choice for almost any fund category, and it can also be said to be a poor choice. The answer depends on the time period. And if multiple time periods are chosen, the numbers tend to blend together, so there is little room for any conclusion whatsoever. In all fund categories, active managers sometimes perform better than the indexes. More often, because of higher expenses, they do not.

There may be something to the argument for indexing large-cap U.S. stocks, because that arena is the world's most heavily researched and thus the most efficient. Also, certain fund categories can be difficult to index because they are very specialized (for example, municipal-bond New York long, or energy limited partnership) or consist of strategies rather than marketplaces (target-date funds, allocation funds). Otherwise, history offers scant counsel. Its signals are a mirage.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own shares in any of the stocks mentioned above.

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