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Passive Success

Index funds are on a roll. Will it persist? 

Shannon Zimmerman, 08/09/2012

So far in 2012, passively managed domestic-equity funds have trumped their actively managed rivals in more ways than one. In addition to outperforming--albeit by modest margins--in most areas of the U.S. stock market for the year to date through Aug. 6, index mutual funds and exchange-traded funds have enjoyed substantial net inflows so far in 2012, too. Meanwhile, actively managed funds as a group continue to hemorrhage assets. 

Through June, the broad universe of actively managed U.S. stock funds has shed nearly $50 billion in 2012, en route to what seems a certain sixth consecutive year of net redemptions. On the passively managed side, however, investors have sent more than $41 billion to domestic-equity vehicles so far this year.

When Will Active Be Loved?
Given the trajectory of recent asset flows, that's a question worth pondering not only for fund company executives who may fear for the health of their business models, but also for fund investors.

Managing flows into and out of a fund comes with the territory for all money managers, of course. But when assets evaporate, persistently and in large sums, even topnotch stock-pickers can be hard pressed to avoid selling shares of companies whose fundamentals and valuations they still like. Even when managers are able to sell into strength, lackluster results can be tough to avoid, at least in relative terms.

And while bulking up on cash in order to hedge against the risk of torrential outflows can be useful in market environments such as 2008's, the tailwind that tactic can provide becomes a headwind in markets like 2009's. It can make a fund difficult to use as part of an asset-allocation game plan, too. With low-cost, low tracking-error index funds, on the other hand, investors get steady exposure to the areas of the market they've targeted for their portfolios.

Buyer's Remorse?
All the above, however, may add up to a contrarian case for investing in active management. Broadly speaking active management is a strategy. And as with all strategies, it's destined to succeed in some markets while lagging in others, at least if history is any guide.

In the 109 three-year rolling periods that occurred between August 2000 and July 2012, for example, the S&P-tracking Vanguard 500 VFINX secured a spot in the large-blend peer group's first or second quartile roughly 46% of the time while landing in the category's third quartile in approximately 54% of the periods.

Further down the market-cap range, Vanguard Small Cap Index NAESX has fared far better than its larger sibling. Still, that low-cost fund, which shadows the MSCI US Small Cap 1750 Index, landed in the small-blend category's third or fourth quartile in roughly 20% of the measurement window's three-year rolling periods. And despite the substantial advantage an expense ratio of just 0.24% provides in a category whose norm is 1.37%, the Vanguard fund surpassed the category average by just 4 cumulative percentage points over the course of the entire 12-year time frame.

Even during market cycles in which passive investing holds sway, moreover, pockets of outperformance can be found among the ranks of actively managed funds. While 2012 has been a good year so far for index investing, the average funds in Morningstar's large-value and mid-cap value peer groups have bested their respective category indexes--the Russell 1000 Value and the Russell Mid Cap Value benchmarks--so far on the year.

Predictive power
As my colleague Russ Kinnel shows here, a fund's price tag is its most predictive attribute. The lower the expense ratio, the better the chances it will outperform its peer group over time. A fund's star rating is only slightly less predictive than its price, presumably in part because, as a backward-looking measure of a fund's risk-adjusted results, the star rating captures the clearest benefit of lower costs: better returns.

Still, while low costs afford index funds a compelling and presumably permanent advantage, the performance data outlined above shows that passive vehicles don't always win the returns battle. It's also worth remembering that comparisons between groups

Shannon Zimmerman is an associate director of fund analysis at Morningstar.
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