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Rekenthaler Report

3 Academics Take Active Managers' Side

However, the effort does not fully convince.

In Defense
"Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds" (Martijn Cremers, Jon Fulkerson, Timothy Riley) sets two records. The first, obviously, is for carrying the longest title of any mutual fund article. The second is for sporting the most extensive bibliography. Of the paper’s 41 pages, 19 are devoted to listing its references.

As suggested by the paper’s headline and by the length of its bibliography, it reviews the existing literature rather than offering new research. That presents a problem: How to dispute the “conventional wisdom” by citing the same articles that shaped the conventional wisdom?

I can’t say that the authors succeeded. Nonetheless, the paper does offer a useful reminder. The general view of indexing, that it is consistently a sound strategy if offered at low cost, is correct. That does not mean, however, as is sometimes written, that actively managed funds are necessarily inferior. There is a difference between saying that indexing is always sensible and saying it is always best.

Generalizing the Lesson
To start, the firmest conclusions about indexing have come from studying a single fund type: diversified U.S. equities. The authors hesitate to generalize about the findings for other fund varieties, such as bonds, real estate, allocation, and international stock, because “there has been far less research” on those subjects and because the work that does exist (they state) tends to use outdated methods.

(The main reason that domestic-stock funds receive the lion’s share of attention is not because they have so many assets and are well-known, but instead because they are the easiest to study. Domestic-stocks funds have a limited number of potential holdings, and the data for those holdings are readily available.)

Not so for many bond funds. Trickier yet are those that hold multiple asset classes, such as target-date or balanced funds.)

This emphasis on U.S. equity funds leads to a subconscious sleight of hand. Academic studies show that active domestic-stock funds have struggled to keep pace with the indexers. There hasn’t been much coverage of other fund varieties, but, at a first glance, the anecdotal evidence looks similar. Voila! Indexing works everywhere.

While I accept that this sleight of hand exists--and indeed, recently took the authors’ side of this debate when discussing a Vanguard publication--I also must grant that the burden of proof lies with active management. It is one thing to recognize that lessons drawn from one investment sector may not translate fully to another. It’s another to demonstrate, specifically, where the opportunities lie. Without that step, it’s difficult to criticize the public’s current approach of “When in doubt, index.”

About Those Stock Funds
The authors have plenty to say about the U.S. equity-fund results, as well. Among their strongest points is their critique of “alpha.” As they point out, while the term is commonly used to mean “manager skill,” the alpha measurement is nowhere near that precise. It captures when a fund’s risk-adjusted performance deviates from that of its benchmark, and whether that is skill, luck, or the residue from an imperfectly fitted benchmark is anybody’s guess.

(A dirty little secret of fund studies is that no matter how carefully one specifies the measurement process, any nonstandard index fund will generate an alpha. Under certain market conditions, even something as simple as an equally weighted S&P 500 index will generate a “statistically significant” alpha. )

They also suggest an angle I had not heard before: anti-survivorship bias. It is commonly recognized that if databases scrub their expired funds, their performance results will be biased upward because only the bad die young. Cleverly, a researcher considered the reverse. What if fund companies were hurting their results by killing their fund children inopportunely before changing market conditions could boost their fortunes?

Apparently, that is indeed the case. Not only do fund investors mistime their purchases and sales, but fund sponsors also do. They launch funds when those investment styles are fashionable, then shut them down when they are unpopular and due to rebound. That pleases me; stupidity likes company.

However, while such a finding compliments active managers’ abilities, it does little for investors’ returns. The improved performance was only theoretical--the results that the funds would have recorded had they remained alive for shareholders to own. But they did not remain alive, and shareholders did not own them. Such are most of the defenses for active managers. They encourage us to think more highly of professional management--but they don’t make us money.

Considering Factors
The remaining support for active management involves bettering the odds. Investors need not purchase just any fund, after all. They can seek funds with strong recent records, those with high active share scores, those with low turnover rates, and so forth. Researchers have found many attributes that improve the candidate pool.

Far be it from me to downplay that effort: I have written a few such articles myself. However, it is unfortunate that, aside from costs, the papers chronicled by the authors each tend to identify a different factor. That raises the possibility of data mining--that the effect appeared for that particular study, for that particular group of funds, over that particular time period, but that the effect is not repeatable. Or, perhaps, it can be repeated, but the upgrade is minor.

Also, the benefits from buffing a pool of funds is less than doing so for equities. When the task is completed, every stock may be bought, at least by professional managers. But nobody will purchase every fund; the attempt is impractical. Thus, even if the theoretical fund research is powerful and identifies a persistent factor, the investor who puts it into practice could fail through bad luck.

In summary, “Conventional Wisdom” provides a fine overview of recent mutual fund literature, as well as a useful reminder of how investment practice glosses over academia’s details. I do not think, though, that the paper will convert many index-fund supporters.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.