Where Should Investors Be Active?

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I'm here today with me is Lee Davidson. He is a senior quantitative analyst at Morningstar. He recently moderated a panel on when it makes sense to be active and when it makes to have a more passive strategy. We'll talk about some of the insights from that panel.

Lee, thanks for joining me.

Lee Davidson: Thank you for having me.

Glaser: Let's talk about this panel a little bit. What were some of the decision points? How do you decide when it makes sense to hire an active manager and when a more passive strategy is really the right way to go?

Davidson: That's definitely one of the things that our panel homed in on. We were thinking, "Okay, let's just take a decision framework to this question, because it's not always going to make sense to always be passive or active in this particular area or this other area." So, the decision criteria that they laid out was this: "Let's look at the distribution of alpha, or excess returns, on a subsector or a category basis. Let's look where active managers have historically been able to outperform their peers in different category benchmarks in great numbers." And essentially what you're looking for is, as an investor, to identify those areas so that you can have a higher probability of success in picking a manager who is going to deliver you excess returns.

Glaser: If there are times an active manager makes sense, then what are some of the criteria for parts of the market where you might want to hire an active manager?

Davidson: That is something that the panel definitely homed in on and spent some time discussing. And they highlighted what Eugene Fama calls the "dusty corners" of the market. So, places where the securities that are traded are maybe more illiquid, maybe it's not as transparent, or there's not as much competitive pressure from different managers. So, some of those areas they highlighted were natural resources, real estate, infrastructure, municipals, and bank loans. Those types of areas where maybe there's not as much pressure competitively, from an industry standpoint, to generate excess returns, so the managers who are operating there have maybe a greater opportunity to do so.

Glaser: Even in these areas of the market that might be more right for active management, you're still going to be paying more for that. How do you know that you're still going to get some bang for your buck, if you're going to be paying that higher fee?

Davidson: So, you have to weigh off the certainty with which fees are going to be extracted from your portfolio, but then you also have to weight it off with the potential for excess performance. And so, that potential for excess performance comes from funds that will not be closet indexers, for example. So, we spent some time discussing what those metrics are that you want to look at.

It's funny. R-squared is typically one of the most quoted metrics that people use for that analysis, and I always think that's a frustrating use case for R-squared because it doesn't mean anything for alpha. You can have alpha of 10% and R-squared of 100% and the equation holds.

Some of the other metrics that people look at: Morningstar also produces things like active share, looking at the total deviations from the index the manager is taking, looking at active risk. So, is this manager actually deviating from the benchmark in a way that you want? When you are going active, you want that different, separate allocation from just a pure, passive portfolio.

Glaser: So, then for the case where you're just looking at a broad-based market index--you just want to own S&P 500--are there times when you think that active management could add value there? Or are those spaces that are more illiquid where you should always be passive?

Davidson: Typically not. Passive investment tends to make sense where there are the most assets going after the largest securities--so, the places where the market is most likely going to be very efficient. One of the things I always come back to is Bill Sharpe's 1994 article, "The Arithmetic of Active Management." In that, he says that 50% of active managers are going to outperform and 50% will underperform. It's a zero-sum game, and so that's especially true when you're looking at the largest marketwide types of sectors like large blend or large value in those types of areas. But when you're getting down into the niche microsector areas, that may be a place at certain points in time where it makes sense to hire an active manager.

Glaser: Lee, thanks for sharing your thoughts on the panel today.

Davidson: Thank you for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.