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Is Perception Reality for Active Managers?

Investors have been migrating in droves to passive management, but is it rational?

Jeffrey Ptak, 12/01/2011

Investors tend to pick actively managed mutual funds based on their perception of what was, what is, and what can be. For example, they often idealize successful long-term managers, believing that their success came through unerring short-term performance, despite the reality that slumps occur routinely (“How We Improve Our Odds of Picking Outperformers,” April/May 2011 issue). They shovel assets to category killers, seemingly unaware that peer groups are shape-shifting, making comparisons complex and, in some cases, perilous (“Pitfalls of Peer Groups,” August/September 2011). And they chase performance with abandon, chucking laggards for the next hot thing (“A Strategy That Loves Performance Chasers,” December 2010/ January 2011).

Perception also appears to be playing a key role in another realm: the migration from active to passive management. Investors have increasingly replaced actively managed stock funds with passive vehicles like exchange-traded funds, shrinking its market share over the past decade. Active management seems to have an image problem like never before.

But is it rational for investors to spurn active management in this fashion? Or is this more of the same binge and purge, with investors allowing emotion--in this case, frustration with disappointing active-investing results--to drive their decisions?

Perhaps the answer depends on what investors should reasonably expect from active managers. A basic investing precept holds that it’s a zero-sum game, with winners largely offsetting losers, thereby preventing a clear majority of active managers from succeeding over the long haul. But what about shorter time periods? What does history suggest our odds are of picking a winning active stock manager over a three-year time frame? And how does the recent performance of active equity managers compare with the norm?

In this piece, I explore those questions in detail and offer some possible explanations for shifts in investor attitudes toward active management. We also explore the implications of trends in active-management success on portfolio construction decisions.

Our Approach
To evaluate the success of active funds, we compiled rolling 36-month excess returns for every actively managed U.S. large-, mid-, and small-cap fund for the 15-year period ended Oct. 31, 2011. We defined “excess returns” as the difference between a fund’s returns and the returns of the S&P 500 (for large-cap funds), Russell Mid-Cap (mid-cap funds), and Russell 2000 (small-cap) indexes.

For each of the 144 rolling periods, we counted the number of active funds that had generated positive excess returns (that is, beaten the relevant index) and divided that figure by the total number of active funds. This quotient represented a success, or “beat,” rate. We compared these beat rates over time to derive a clearer sense of patterns in active management’s success. Exhibit 1 shows the beat rates of all U.S.-stock funds (including averages) over the 15-year period we studied.

In examining the trend in beat rates, a few traits jump out. First, there is a high degree of variability, with active managers having their way with the benchmark indexes at times, only to badly lag in other periods. For example, nearly all active large-cap managers lagged the S&P 500 in the late 1990s, when a narrow swath of large, growth-oriented firms propelled the index higher. Yet, their fortunes turned just a few years later when value stocks, which active large-cap managers had tilted toward, held up better than the tech-dominated benchmark.

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