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Active Funds That Beat the Index Trend

Christine Benz
Shannon Zimmerman

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

Investors have increasingly been buying index funds and exchange-traded funds at the expensive actively managed products. Joining me to discuss whether recent performance supports that trend is Shannon Zimmerman, associate director of fund analysis with Morningstar.

Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, this is really the big question for many fund investors: Whether to invest in actively managed products or in index products. When you look at the data over the past five years, what do they say about the performance of these two fund types?

Zimmerman: If you look at the last five years--of course it's a nice bull run, a long bull run by historical standards--and by and large the typical active manager has not managed to beat a relevant benchmark.

In the smaller-cap categories, I took a look at it style-box square by style-box square. In the smaller-cap categories, actively managed funds did better, but still the best-performing category in terms of being able to beat the Russell 2000 among the small-cap categories, was small blend. And roughly half of the funds in the small-blend category surpassed what the Russell 2000 did over the last five years.

Benz: So small-blend active managers did best.

How about when you look at the large-cap funds? How did those active managers do there?

Zimmerman: Less well. The worst-performing peer group versus the relevant benchmark was mid-cap blend. If you look at that category versus the S&P 400, which is historically a very tough-to-beat index, sure enough, it was tough to beat over the last five years as well. About 11% of the funds over that five-year period in the mid-cap blend category surpassed the S&P 400.

It was a little bit better as you look at the large-cap categories, but not that much better. In the large-value category, for instance, about 17% of the funds surpassed the Russell 1000 value.

Benz: Not a great rate of outperformance there.

Zimmerman: No.

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Benz: The time period you're looking at, the past five years, that's a very specific time period and generally really good for stocks. Does that have a role, perhaps, in these results?

Zimmerman: I think it probably does. The important thing to remember is, everybody did well. Active, passive--it doesn't matter. Over the last five years, the market has been, as we were saying, on a nice rally.

But I think that a lot of investors, particularly coming out of 2008, are looking to active managers to help them dodge bullets whenever the market turns south. In an upmarket, index funds are going to be fully invested. Active managers aren't always going to be fully invested. So, in a market like we've seen over the last five years, that's going to be a drag. Active managers have not had an opportunity to dodge too many bullets. There have been pockets when the market was rocky, and there were a couple of quarters when it was very rocky. And if you look into those time periods, sure enough, active management did better. But that is just a drop in the bucket over the last five years. There's really not enough of a timeframe to draw conclusions from.

But by and large, I think you're right that in a rising market, which has been on this five-year tear, index funds being fully invested is an advantage that is hard to overcome for any fund that has a meaningful sum of cash.

Benz: I guess it's important to point out, we're not looking at risk-adjusted return here. We're just looking at the return piece.

Zimmerman: Pure total return. That's right.

Benz: Shannon, you brought a few names of funds that have managed to outperform their respective benchmarks over this particular time period. Let's start with the large-cap fund that you wanted to talk about; it's a John Hancock fund.

Zimmerman: John Hancock Disciplined Value, which is run by a subadvisor, Robeco of Boston Partners, and they have an interesting approach. All the funds that we'll talk about are fundamental in terms of the research that the management team does to put together the portfolio.

That's true of Disciplined Value. They are doing fundamental research. They are looking into the company's financials, its growth prospects, doing valuation work to make sure that they are not overpaying. In fact, they want to underpay versus what they think the stock is exactly worth.

But then, unlike the other funds that we'll talk about, this fund is somewhat unique in this realm of the market. There's a momentum component. It's "quantamental," in a way, but the way that they work it is not price momentum; it's earnings momentum --what they call business momentum.

They're looking for upside earnings surprises, which, if you look at the academic literature, it does seem to be the case that price momentum is a persistent premium, even more so than the small-cap premium or the value premium, which everybody is aware of. Price momentum has a terrific track record even longer than those premiums. And earnings growth moves in tandem with price momentum as well. So that's what they are focusing on, although again it's more about the upside earnings surprises, and that's a good proxy for a company's health and its growth prospects as well.

Benz: That is a fund that you would need to buy through an advisor; you'd pay a sales charge?

Zimmerman: That's right.

Benz: Another fund, a mid-cap fund, you want to look at is a no-load fund. It's T. Rowe Price Mid Cap Growth. What about it and its strategy has helped it outperform?

Zimmerman: Like the Robeco Fund, the Disciplined Value Fund, it's a fundamental-focused fund in terms of the research they do to put together the portfolio. It's not especially concentrated, relatively low turnover. The expense ratio is attractive. It has all the good qualities that you want to see in a T. Rowe Fund. They are a fine fund company for all of those reasons, because it's true for most of the funds in their lineup. They are very sensibly managed. T. Rowe Price does have some more aggressive funds; this is not one of them.

Benz: In terms of small-cap funds that have outperformed, one that you want to talk about is Brown Capital Management Small Company. It's not a household name. It's got kind of a unique strategy. Let's talk about what it has done and why it has done so well.

Zimmerman: Again, as with the other funds that we are discussing, it's fundamentally focused. It's somewhat concentrated; it's not especially cheap. And they are looking for moats. I don't know that our equity analysts would assign moats to lot of these companies, but in terms of the way the management team at the fund works, they're looking for competitive advantages among small-cap stocks--in this case, small-cap growth stocks. And those are hard to come by.

Even when you find a company in that part of the market that you think has some competitive advantages relative to others in the industry, there is still a lot of volatility that comes with that territory. Even the most financially sound small-growth stock can be wild and wooly if the market gets gyrating.

Benz: Taking a step back, how should investors think about this data? Do you see this as confirmation that investors' recent tendency to want to buy index products is on the right track? How should investors make use of this data?

Zimmerman: It's never either/or. You don't have to be all passive or all active. In my own thinking, in my own portfolio, I think that it makes sense to have some of each, because at the end of the day, what is passive investing? What's active investing? Those are two, in the broader sense, strategies. In some environments, active will lead the way, as we've seen historically, and in other environments, as we've seen over the last five years, in the broadest sense, passive has led the way.

An important thing to remember, too, is that we're looking at things in the aggregate. You don't have to invest in the aggregate. You're not throwing a dart. You're not investing in the typical fund. Just do some very simple screens for a long-tenured manager, a good track record on that management team's watch, low expenses. Has the fund behaved historically in ways that are, not entirely predictable--it's never going to be entirely predictable--but has the fund behaved in ways that you would expect given its strategy?

These are all the things that Morningstar's fund research group is looking at when they're giving medals, or not, to the funds that we evaluate. You want to feel confident that the historical patterns that a fund has exhibited over time have been repeatable enough that you can rely on those, to some large degree, to feel confident that it will continue to do that into the future.

Benz: So, for most investors, the right answer isn't either/or; it's maybe both.

Zimmerman: That's what I would say.

Benz: Shannon, thank you so much for being here.

Zimmerman: Good to be with you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.