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By Ben Johnson, CFA and Christine Benz | 04-16-2015 04:00 PM

Active and Index Funds: How Do They Really Stack Up?

Adjusting for several factors--including fees, the time period, and the composition of the benchmark versus managers' real opportunity set--impacts the comparison.

Note: This video is part of Morningstar's April 2015 Active, Passive, and In-Between special report.

Christine Benz: Hi, I'm Christine Benz for How do active funds stack up to passive? Joining me to share some general findings on that topic as well as some rules of the road for making these comparisons is Ben Johnson; he is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me.

Benz: Ben, oftentimes, you hear these comparisons made where you might hear, "Well, 79% of active equity funds have lagged the S&P 500 over the past five years"--or whatever time period it might be. What are the pitfalls of comparing a really broad universe of funds with a single benchmark--even one as broad as the S&P 500?

Johnson: I think the greatest pitfall, or the greatest shortfall, of those comparisons is that they don't really adequately affect investors' reality; they don't adequately reflect investors' opportunity set. So, it's looking at active managers and holding them up against an index, and it's holding them up against a single index. It's important to note that the choice of that index can have a pretty meaningful effect on the end results of such an exercise. And it also holds them up against an index, [which] is really just a theoretical construct. Now, there are index funds that may track that specific index, which I would argue are a more realistic reflection of the true trade-offs that investors face. So, it's important to note that an index, in isolation, does not reflect the costs involved in tracking that index--[granted,] they are often very small.

A more realistic approach to this is looking more holistically at active managers and active strategies' performance relative to passive alternatives with like objectives. So, in Morningstar Categories, for instance, how have active managers in our U.S. large-value category fared relative to all of the various passive options in that strategy? That reflects investors' choices, their opportunity set, and their reality at the end of the day.

Benz: So, you want to be comparing with the appropriate category, and then also be comparing investable [active] fund type versus investable passive fund type.

Johnson: Absolutely.

Benz: So, in addition to that, when you look at active versus index fund performance, you also like to asset-weight the data. Let's talk about what that means, and also what value you think that has.

Johnson: I think the value of asset-weighting the figures as opposed to equally weighting them is that it more accurately portrays the decisions that investors are actually making when it comes to investing in index funds and when it comes to investing in actively managed funds. Now, what you see in terms of the outcomes of asset-weighting relative to equal-weighting is that directionally the results are more favorable. So, what we see is that investors aren't choosing average funds--be their actively managed or passively managed; but what we also see is that the success ratio in terms of investors' choices, or their preferred active funds in a given category, are faring really only marginally better than the average randomly selected fund in a given category. So, they are selecting better-than-average funds, but those funds are only marginally better than average.

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