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By Christine Benz | 09-15-2011 05:17 PM

Where Active Management Is Adding Value

Data seem to support the approach of using index funds for core positions and active management for smaller-cap and emerging-markets positions, say Ibbotson's John Thompson and Larry Cao.

Christine Benz: Hi, I'm Christine Benz from Morningstar.com.

Many investors use index funds together with actively managed offerings, but they might grapple with where to go active and where to use the index funds.

Here to share some recent research into this topic are two of my colleagues at Morningstar Ibbotson, Larry Cao and John Thompson.

Thanks for being here gentlemen. It's some really interesting and useful research you've just done.

John, I am wondering if you can start by sharing what you did and how you went about looking at the categories in which active managers have added value and where they have not?

John Thompson: Sure. Well, we develop active-passive portfolios for our clients. So one of the things we wanted to do is get a better understanding of where the active managers add value and where they may not. So what we did is we looked at the managers using Morningstar categories and divvying up the managers and looking to see if they actually added alpha in their category as a whole.

Benz: So you didn't just say okay, you're in the mid-cap growth category, so we're going to compare you to the Russell Mid Cap Growth Index. You did something a little different?

Thompson: We did do something a little bit different. What we did is we ran regression analysis called returns-based style analysis, and we looked at what the managers' investment style, each manager's investment style was, and how it was unique to each manager first, and then that's how we measured the alpha, and then we grouped the categories together to get those alpha scores and then looked to see whether they are providing alpha or not.

Benz: So, if say a mid-cap growth manager had some small-cap growth, some large-cap growth, mid-cap value, you would actually be able to evaluate how they did relative to other funds using those styles?

Thompson: That's exactly right. So really what we're trying to do is, if these managers are adding value, are they adding value over their specific strategy or not?

Benz: Okay, good. Well, Larry, now let's talk about what you found. How about in the large-cap space, where I know a lot of investors like to index because they say that that's a highly liquid market, lots of research out there. What did you find?

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