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Where Active Has Beaten Passive This Year

Christine Benz
Shannon Zimmerman

Christine Benz: Hi, I'm Christine Benz for

The typical actively managed fund badly underperformed its benchmark in 2011. Joining me to give a recap of what's going on with active versus index fund performance so far in 2012 is Shannon Zimmerman; he is associate director of fund analysis at Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Absolutely. Good to be with you again, Christine.

Benz: Shannon let's talk about active versus index fund performance. In 2011 the active funds really got clobbered relative to their benchmarks. What are you seeing as you look across the data so far this year?

Zimmerman: It's clobbering time again.

Benz: Same thing.

Zimmerman: It's not as dramatic, I think, so far at least as it was in 2011, but in every diversified domestic equity category that we track here at Morningstar--except two, and we'll talk about those in just a minute--the comparable index has beaten the average fund in those categories. The S&P 500 has beaten the typical large-blend fund. The S&P MidCap 400, which has always been a very difficult benchmark for active managers to beat, has beaten the typical mid-cap blend fund, and the same is true for the Russell 2000 versus small-cap blend.

Benz: So what are the two exceptions? What categories have active managers outperformed in.

Zimmerman: The envelope please. Large-cap value and mid-cap value. And you think about it--it kind of stands to reason, right? So value managers are sort of, by mandate, looking for bargains, and they are better positioned than the sort of dumb, so to speak, index to identify where the opportunities are. And then value is not as a style of investing any kind of monolith, and so some people are, like Marty Whitman, comfortable looking for distressed stories. And others are looking for relative value plays. If a space was going to outperform during a period when index investing was largely pacing the market, it seems to make sense to me that it would be in the value space.

Benz: So the value indexes might just own beaten-down junky companies, and they would ... have to do so, whereas the actively managed fund has more oversight and can make those active choices.

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Zimmerman: Exactly right, and so the rules that govern the indices, too, can sometimes be somewhat counterintuitive. I think it was ExxonMobil that went from the Russell 1000 Value to the Russell 1000 Growth for a period of time there, and that is sort of just an accident of index. I'm sure if that's maintained its position in growth bogey, but value managers, of course, aren't slave to that; they can make their own choices about what constitutes a value stock.

Benz: Shannon, how about the small-cap space. That historically has been an area where active managers have done a pretty good job versus their benchmarks.

Zimmerman: That's true, that kind of stands to reason as well, because that's the least covered, in terms of exposure to analyst or analyst coverage, of the domestic equity space. And so there is more opportunity there because it's a less efficient market. Interestingly, small-cap value managers have done the best. They have still outperformed the relevant index in that space, but…

Benz: You mean they've underperformed.

Zimmerman: Exactly.

Benz: But by a smaller margin.

Zimmerman: Than the others. That’s right. So some of that inefficiency that they are still able to take advantage of I think is showing up in that measure of the margin of victory, rather, being so small. 

Benz: Now one thing I know you and the team have been writing about is the role of Apple, and its role in indexes, its role in mutual funds. How does that one stock figure into all of this? Has the typical manager underweighted Apple versus benchmarks, or what's going on there?

Zimmerman: Well, a couple of interesting things out of that. One of my colleagues, Dan Culloton, earlier in the year wrote a piece about what was driving the outperformance in the large-cap blend space, I believe. In that category it turned out that the funds that were more heavily exposed to Apple, and Apple has been going gangbusters until quite recently, were doing better than the typical fund that wasn't so heavily exposed to Apple.

The question of underweight versus the index, or overweight versus index, is kind of an interesting one, too. I was talking with one of the managers of the funds that I cover, John Hancock U.S. Global Leaders Growth. That fund, I think, has a 7% position in Apple, substantial position. It's a concentrated fund, but they tend to spread the assets across 20-25 names.

So, the manager of that fund was explaining to me that he gets questions and concerns from investors or consultants who say, why you underweight Apple? Well, wait a minute; I have a 7% position in this company. But in the index, in the Russell 1000 Growth, I think it's a 9% or 10% position. So that looks like it shows up as an underweight, but people need to keep in mind not just the relative size of a position, but the absolute size of a position, particularly in a fund like that, when it is a concentrated fund already. It's running risk just in terms of the few names that it holds, and then if it's jamming a bunch of assets into individual names even within that collection, that can really exacerbate volatility.

Benz: So you and the team, Shannon, have been tracking active versus index fund performance. It looks like one area in which index products are clearly winning is in the realm of gathering investor dollars. What's going on there?

Zimmerman: Well, it's dramatic, and at this point, I think there is more speculation than there is hard data around what's going on. I think one of the things that's happened is, over the last 10 years, you've seen intermediaries play a much bigger role in managing the portfolios of individual investors.

Benz: So you mean financial advisors.

Zimmerman: Exactly, folks who use to go to the platforms, the non-transaction fee platforms or maybe they would pay a transaction fee and buy their own funds, that's happening less and less. So you have an advisor class that really is sort of burgeoning, and they look around, and they are savvy folks, and they say, well, over time, cheaper vehicles tend to outperform more expensive ones, and in some cases, I believe, they want to add value to their clients' portfolios by doing the asset allocation work for them.

So if you've got these dirt-cheap vehicles, traditional index mutual funds or ETFs, that are a fraction of the cost of a typical actively managed fund, well then, why not? If you think that your mandate is to do that asset allocation work, and if you think you know how to, not time the market, but construct a portfolio in thoughtful way, why not avail yourself of the cheaper vehicles.

Benz: So it sounds like you don't think this is a trend that will be going away soon.

Zimmerman: Well, never say never, and if there was a sharp reversal than what we are seeing this year or last year ...

Benz: ... with performance ...

Zimmerman: ... exactly, then sure, people might say, you know what, I've had enough of that. I hear my friends who are in actively managed mutual funds who are doing much better than I am in these vehicles. Sure they're cheap, but they are not outperforming.

People do tend to chase performance, most often in the wrong direction. But it's all, I think, probably cyclical, and it's important to remember, too, that it's not an either/or proposition. You can have both index funds and actively managed funds in your portfolio. And if you think about it at the level of diversifying your fund around strategies, well, when you get right down to it, or investing in passively managed vehicles is just one strategy. Investing in actively managed vehicles is another strategy. It might make sense to have exposure to both to complement one another.

Benz: So mix and match the two.

Zimmerman: Exactly.

Benz: Shannon, thank you. It's always great to hear your insights into all of these topics. We appreciate you being here.

Zimmerman: Thank you Christine.

Benz: Thanks for watching I'm Christine Benz for