ETF Specialist

Don't Try to Time Active and Passive Equity Exposure

Adam McCullough, CFA

Earlier this year, our team put Dunn’s Law to the test to determine whether stylistic differences between active and passive managers could help explain the variation of active fund managers’ success rates from Morningstar’s Active/Passive Barometer. Dunn’s Law predicts an inverse relationship between active managers’ index-relative performance and the performance of their investment style. That’s because active managers tend to be less style-pure than the indexes against which they are benchmarked. So, they should benefit when adjacent categories do better than their own and do worse when their Morningstar Category enjoys strong relative performance.

In this article, I test how well predictions from Dunn’s Law stack up when using asset-weighted return differences between active and passive funds to measure manager success rather than success rates. Success rates represent the percentage of funds in a Morningstar category that survive and outperform the equally weighted average passive fund return over a specified period. In this case, success is a binary measure, and gives all funds equal weighting, regardless of assets under management.