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How Can You Boost Your Base Rate When Searching for Winning Funds?

Morningstar's Active/Passive Barometer is a novel way of measuring one's odds of picking a winner.

Ben Johnson, 03/29/2017

In his book “Thinking, Fast and Slow,”[1] Nobel Prize-winning psychologist Daniel Kahneman discusses how he stumbled upon two different approaches to forecasting while working for Israel’s Ministry of Education to write a high school textbook on judgment and decision-making.

Kahneman and his longtime collaborator Amos Tversky ultimately branded these two schools of forecasting “the inside view” and “the outside view.” The inside view is deeply personal. In constructing a forecast based on the inside view, we focus very narrowly on our own unique experiences and situation and extrapolate from there. (For example, I’m an above-average driver with a squeaky-clean driving history about to go on a short trip in fair weather. The odds of me getting in a fender-bender are almost nil.)

On the other hand, a forecast based on the outside view starts with a survey of the broader population and is refined based on any specifics regarding the circum­stances. (Let’s start with the odds of any driver getting in a fender bender regardless of driving history, the distance travelled, or weather conditions, and go from there.) The outside view is anchored to a base rate.

Kahneman explains the concept of base rates like this:

“…it provided a reasonable basis for a baseline predic­tion: the prediction you make about a case if you know nothing except the category to which it belongs. This should be the anchor for further adjustments. If you are asked to guess the height of a woman and all you know is that she lives in New York City, for example, your baseline prediction is your best guess of the average height of women in the city. If you are now given case-specific information—that the woman’s son is the starting center of his high school basketball team—you will adjust your estimate.”

Depending on the problem at hand, starting from the outside and working in may be a recipe for better predictions and, thus, better decisions. I would argue that this approach has a multitude of applications within the realm of investing. I’ll share with you some base-rate data that is specific to success rates among active fund managers and how investors can take the outside view to begin to zero in on winners.

Morningstar Active/Passive Barometer 
In 2015 I, along with some of my colleagues, began working on a project that would more systematically measure base rates on investors’ behalf with respect to selecting successful active managers in a given Morningstar Category. Specifically, we were looking to answer this question: If an investor were to select an actively managed fund at random from a particular category, what are the odds that fund will survive and outperform its passive peers in any given time period? The product of our efforts is the Morningstar Active/Passive Barometer.

The Active/Passive Barometer is a semiannual report that measures the performance of U.S. active managers against their passive peers within their respective categories. The Active/Passive Barometer report is unique in the way it measures active managers’ success relative to the actual, net-of-fee performance of passive funds rather than an index, which isn’t investable.

Ben Johnson is Morningstar’s Director of European ETF Research.

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