Christine Benz: Hi, I'm Christine Benz from Morningstar And I'm here today with John Rekenthaler. He's vice-president of research for Morningstar. John, thanks for being here.
John Rekenthaler: Any time, Christine.
Benz: You just presented some great information on what we do know about mutual funds. And one of the things you talked about was index versus active. This is probably the debate in the field of mutual funds. What did the data tell us about whether you're better off going with an actively managed fund or going with a passively managed vehicle?
Rekenthaler: Well, in aggregate, when you look at funds, what you find is that, before fees, the typical fund and the typical fund manager pretty much matches up with the index that most closely is related, or matches, with the fund. That's true for domestic stock funds, international funds, fixed income, and so forth.
Benz: So when you look at these categories in aggregate versus their respective indexes...
Rekenthaler: In aggregate. It's not the portfolio managers are inferior. It's not that they're superior. In fact, maybe a little bit, in a way, you could say they're superior, because there's some trading costs associated with them and they're able to overcome the trading costs by matching the returns of the index.
What they're not able to overcome, in the aggregate, are the underlying expense ratios. So about two-thirds of fund managers will underperform over a long period of time. And that's really just due to the expense ratio. It's not due to failure to execute. Again, I'm always talking about the aggregate numbers, right?Read Full Transcript
Benz: Right. So sometimes you can see themes bubble up where it might look like one category, maybe small caps, would be a good place to buy an actively managed fund, because they have shown a good track record of beating the indexes. Do you seen any trends like that, when you look across the data?
Rekenthaler: Those tend to be accidents of a time period.
Rekenthaler: Basically, the mechanism is if an asset class has performed relatively poorly, active managers tend to look well, because they probably owned something that's outside the asset class.
Rekenthaler: Not just cash but even other types of investments; active managers are rarely bulleted so that they only own a very narrow slice of things. The indexes that they're compared against are narrower than what the funds really are.
Conversely, if an index performs very, very well, better than anything else, it's going to be very difficult for an active manager to keep pace with it. So a lot of these studies that say that this is the best area to index, or that are really driven by the recent market returns, or the market returns over that time period. Another time period, you get a different conclusion.
Benz: So just a whole lot of noise. Another thing you talked about is whether there are any factors, specific mutual fund characteristics that you want to look for, because they tend to be predictive of future performance. Can you talk about what your data shows about that issue?
Rekenthaler: There's two items that are statistically significant for future performance. In neither case is there anything close to a guarantee. Right, if you want guarantees, this is not... Investing in general is not the place to be.
Benz: Buy a money market fund.
Rekenthaler: Well, buy a money market fund or a Treasury, right? But when you get a little further out on a risk-return spectrum, there aren't guarantees. Certainly true of mutual funds.
Costs, as I mentioned, are predictive. And historic risk-return versus category. The Morningstar star rating, but it could be an alpha measure or other kinds of risk-adjusted measures, also have some predictability over most time periods.
So you're getting the odds in your favor if you're finding the low-cost fund that's performed well on a risk-return basis, not just return only but risk-return basis, relative to others in the category. Those are the starting points.
Benz: So those things combined together could be good starting points. And then, of course, you want to do additional research into whether...
Rekenthaler: You want to do additional research. Probably the third item, that I'm not quite ready to put in as being as proven as those two, would be the work that Morningstar's been doing on stewardship. That also appears to be meaningful and somewhat predictive. So that if you end up with a fund that has a high Stewardship Grade, in addition to low cost and a good risk-adjusted performance, you've got three factors working for you now.
Benz: OK, sounds good. I'll look forward to the research in that area, too, John.
Rekenthaler: We'll keep working.
Benz: Thanks, John.