Does Active Managers' Performance Hinge on Investment Style?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Most actively managed mutual funds underperform their index peers over time, but they might look better in some environments than others. Joining me to share some research on this topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, you recently wrote a research paper where you examined what's called Dunn's Law. Let's talk about the law and what you did to show whether, in fact, it has held up when you examine actively managed mutual funds' performance.

Bryan: Dunn's Law is based on this idea that an index is the purest representation of a given investment style. Let's take large growth, for example. When large growth as an investment style does really well, index funds that provide exposure to large growth stocks should be harder to beat than active managers which provide less clean exposure to large-growth stocks. For example, if I am an active manager in the Morningstar large-growth category, I might own some stocks that actually might fall more into the mid-cap growth category or into the large-blend categories.

Benz: Or foreign stocks.

Bryan: Or foreign stocks. I have more latitude to color outside the lines. These out-of-line bets can either help or hurt my performance. When large growth does really well, my holdings outside of that particular category can hold the performance of the active fund back. Conversely, if large growth does really poorly, index funds that provide cleaner exposure to large growth should be easier to beat for funds that are able to color outside the lines.

Benz: The ability to hold cash is another dimension to this, that active managers can hold cash whereas index fund investors expect their index funds to be fully invested at all times?

Bryan: That's right. When the market is trending upward, that cash balance that a lot of active managers have can hold them back. Conversely, when the market starts to sell off, it can be helpful to have a little bit of money on the sidelines and that can provide better downside protection, allowing active managers to outperform during market downturns.

Benz: You looked back over a period of years and you examined several Morningstar categories. Your goal was to see if, in fact, looking back did Dunn's Law prevail. What did you find when you looked at the data?

Bryan: We found some moderate support for Dunn's Law, the idea that stylistic differences between active and passive managers can influence the differences in success rates that we see over time. What we found was that although these differences in style are important for explaining the variation in performance that we see, the results didn't cleanly line up with what we were expecting. For example, as we expected, when the market tended to do better, active managers tended to do worse relative to their index peers because their cash balance held them back.

Benz: Right. Or maybe their foreign stock holdings or whatever …

Bryan: Exactly. We also found that when foreign stocks outperformed U.S. stocks, active managers tended to do a little bit better because they tended to own more non-U.S. stocks than their index counterparts, which weren't allowed to hold those stocks.

Benz: That makes sense.

Bryan: But we didn't always find that large managers didn't always do better relative to their index peers when small-cap stocks outperform--this we were kind of expecting from Dunn's Law, because a lot of times active managers might overweight some of the smaller stocks within their respective market segments. The results weren't perfectly clean, but they lend credence to the idea that differences between the composition of the index portfolio and the active portfolios influence the variation in performance that we saw over time.

Benz: In terms of how investors should think about this data, how should they incorporate it into their process, if at all? If they know that their active funds may in fact underperform at times when a given market segment is really rocking the house, what should they do with that information?

Bryan: Well, the short answer is, not a lot. You shouldn't worry about this being a stock-pickers' market and overweighting …

Benz: You sometimes hear that.

Bryan: You do hear that and really the key issue isn't necessarily whether this is a stock-pickers' market or not. It really boils down to how well does the index represent what active managers are doing, because regardless of how efficient or inefficient the market is at any given point in time, if an index matches what all active managers are doing, the performance gross of fees should be the same. It really boils down to, are there important differences between the composition of an index and the composition of the typical active fund in the category. You do find those differences in some categories more than others. For example, investment-grade bond: index funds tend to overweight treasuries and underweight corporate credit. In periods when credit risk pays off, active managers are going to look pretty good.

Benz: That's been layup for many active managers for many years, right?

Bryan: Exactly. These stylistic differences between active managers and index managers influence the performance of active managers relative to their benchmarks. But you shouldn't try to time your exposure to active managers on the basis of that, because that's akin to basically trying to time the performance of different investment styles and that's very difficult to do. I don't think you should try to time your exposure to active versus passive. Your best bet is to stick with low-cost active managers in whom you have really high conviction and to stick with those managers over time. If your manager looks different than the benchmark, there's times when that's going to work out and there's times when it's not going to work out. But to benefit from those active bets, you really have to have the patience to stick with that manager through thick and thin. If you keeps your costs low, that gives you a lower hurdle to overcome and improves your odds of actually being successful.

Benz: You are not saying populate my whole portfolio with active funds, but to the extent that I have active funds in my portfolio, be prepared to put up with those periods of inevitable underperformance, and there may be periods when my active fund will outperform?

Bryan: That's right. I mean, the message here is that active management is a difficult game. We know that over time most active managers don't outperform. Now, that's not to say that indexing is the best way to go all the time. But it does mean that you really do have to have conviction and you have to have patience. You should go into an active-managed fund with eyes wide open knowing that there's no assurance that he waited to beat the market.

Benz: Interesting research. Thank you so much for being here to share it with us.

Bryan: Thank you for having me.

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