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Give Peace a Chance in the Active vs. Passive Debate

Indexing works, but the odds of picking winning active funds aren't as bad as they seem.

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I had thought another article about active and passive funds would be about as exciting as rearranging my sock drawer, but then I caught wind of this donnybrook in the user comment section of this video that my colleague Scott Burns, director of ETF analysis, conducted with index proponent Rick Ferri.

In a nutshell, Ferri says his research shows that very few active managers can beat the market over time and the probability of putting together a portfolio of five to 10 actively managed funds that will outperform a competing portfolio of index funds over a 20-year period is practically nil. Ding! That unleashed a torrent of comments from both sides that reminded me of the old "Point/Counterpoint" segment from back in the '70s on Saturday Night Live. Some users clearly view this as a black-and-white issue and will put forth a lot of effort trying to discredit the other side.

Shades of Gray
I've learned that the truth is often in the middle of such contentious issues, and the only way to find it is to run your own data to see what questions percolate up from there.

So, I mashed some data on active and passively managed domestic-equity funds for the past 10- and 15-year periods. To expedite matters, I restricted the data set, and I'll say up front that this could have influenced the results. I looked at the nine domestic-equity categories of the Morningstar Style Box that our asset data indicates are where most investors buy their stock funds. And I only included the oldest share classes because there weren't many funds with more than one class and a 15-year record.

Like most, I looked first at the basic performance score card for active funds against the S&P 500 Index and  Vanguard Total Stock Market Index (VTSMX). Doing that introduces market-cap bias, which gives the active funds an edge. But as we'll see below, the vast majority of domestic-equity index money for the past 15 years has been anchored in funds mirroring the S&P 500 and Wilshire 5000 indexes, so these benchmarks represent where index investors have actually put their money. At this point, the strategy of mixing a variety of indexes is more theory than practice.

I buttressed this data by factoring in the scale of outperformance by the active funds that beat the benchmarks and the degree of underperformance by those that lagged. And finally, I looked at asset weights among the winners and losers to see where investors have put their money over time.

Keep in mind that this isn't a comprehensive academic study. Rather, it's a quick primer to point out areas for further study. Still, some interesting patterns emerged.

A Different Score Card
First, active equity funds did a better job than I expected. About 65% of the active funds in the nine equity style-box categories beat the S&P 500 and Vanguard Total Stock Market Index over the past decade. That drops to just a hair more than half for the 15-year period--still solid. It is important to note that the data set doesn't control for survivorship bias, which would reduce the success rate. Whether it would drop it all the way to the 30% rate commonly cited is unclear.

It doesn't matter anyhow. That's because the real question should be: How hard is it to find and select funds that succeed? Thinking of matters this way helps mitigate the tendency folks have to look at a data set and see that the typical member or most of the population can't beat the average or some higher hurdle, causing them to conclude it's nearly impossible for anyone to succeed. This tendency is prevalent in financial-trend analysis.

But we rarely take the same tack in other parts of our lives. Nor should we. Parent don't tell their kids that because the typical student on a bell curve gets a C they shouldn't try for an A or that it's nearly impossible to attain that grade solely because most students don't get A's. Similarly, the typical restaurant in Chicago is average--or maybe even poor--but that doesn't mean it's difficult to do a little research and find a good one.

Cast in the Fishiest Waters
Same goes for fund selection. The claim that it's nearly impossible for an investor to put together a portfolio of five active funds that beats the market over time strikes me as odd. That's because, frankly, I'm no brainiac and I've done it. And it's not because I'm a fund analyst. I came to Morningstar in 1994 to work on a foreign equity product and had limited fund knowledge. Within a few months I bought a set of funds that I still own and they've all beaten the market over the past 16 years. My secret? I did basic research using materials readily available for free at any public library, mainly the Morningstar Mutual Fund binder. I read some of my Morningstar predecessors' and current colleagues' analyses and only bought funds they expressed high confidence in. That's it.

I'm not alone. Many of my friends tell similar stories. And I think Morningstar user mrpcid hit the nail on the head posting one of the earliest comments on the Ferri video, saying that the flaw with some academic studies is that they act as if investors pick their actively managed funds at random from the entire pool of funds. But in reality, they use research from firms such as Morningstar to narrow the field, avoiding obviously horrible funds while focusing their efforts on what the military calls a target-rich environment. In this case, it is the small group of funds with numerous favorable characteristics that are not too hard to identify and which tend to endure, such as proven managers with a repeatable process, good stewardship, reasonable costs, and a manageable asset base. As my colleague Russ Kinnel showed in this article, cheap funds--index or active--have a greater chance of success. Focusing only on this subset of funds with lots going for them greatly ups the odds of success.

The list of active equity fund winners reflects this. It's largely a list of funds that Morningstar analysts have long recommended, with most winners overlapping with our  Analyst Picks and the Morningstar 500. So, investors who used these lists as their starting point greatly enhanced their chances of picking market-beaters. In a study for Morningstar FundInvestor, I looked at the Morningstar 500 and found that more than 70% of its funds topped their broad-market and category-specific indexes over time, much higher than the overall success rate. By definition, and by the tiniest of margins, all the index funds in the Morningstar 500 fell into the 30% that lagged. This doesn't diminish the index funds' value, but it highlights that picking active funds from a smaller group of funds with many positive attributes greatly enhances the success rate. For example, our Analyst Picks also have consistently beaten the averages and their benchmarks.

Weighing In
Scale matters, too. The data shows that the outperformance of the winning active funds is much bigger than the losers' underperformance. For example, there are many more funds in the set that beat the market by more than 2 percentage points per year over the past 15 years than the reverse.

So, a portfolio of active funds culled over time from the subset of funds in the Morningstar 500 would seemingly have had a great chance of outperforming. Even if an investor defied the odds and managed to pick four funds from the 30% of that list that lagged the market and just one that topped it, there'd still be a chance that the one winner could single-handedly offset the damage from the others. That's because the list of winners includes a good number of funds like  Meridian Value (MVALX),  Fairholme (FAIRX), and  The Delafield Fund (DEFIX) that have crushed the market by a huge margin, while most of the Morningstar 500's laggards have underperformed by a small margin.

Voting With Their Feet
That sounds great on paper, but what have investors done? Turns out, they know quality when they see it. About 80% of the total assets in active equity funds are held in funds that have beaten the market over the past 15 years. For sure, there's been performance-chasing, but the flow data indicates that investors have done a decent job of avoiding the losers and buying the winners, perhaps switching from one winner to another.

And it turns out that using the S&P 500 and Vanguard Total Stock Market Index as benchmarks was spot on. About 70% of domestic-equity index assets are in S&P 500 index funds, index funds with nearly perfect correlations with the S&P 500, or Vanguard Total Stock Market Index. In fact, four funds,  Vanguard 500 Index (VFINX), Vanguard Total Stock Market Index,  Vanguard Institutional Index (VINIX), and  Fidelity Spartan 500 Index (FUSEX), together soak up more than half the domestic-equity index assets by themselves.

New Kid in Town
This concentration of index assets in just one type of fund is a reminder that the recent talk about tactical allocation among numerous style-specific index funds is largely theoretical. A back-test run today, for example, would show that having a slug of assets in funds tracking the S&P Midcap 400 and MSCI U.S. Small Cap Value indexes was the way to go for the past 10 years. Trouble is, I don't recall many people telling investors to heavily overweight those indexes a decade back--when they would have had to have done so to fully benefit. The two funds tracking these indexes that have 10-year records have only a small slice of the total index assets pie and the bulk of their inflows came in recent years, so it's safe to say that most index investors' portfolios didn't have much exposure to two of the past decade's hottest-performing indexes.

That's not to say that active allocation with indexes can't work going forward. But having the tools to do a job--there are now specialized index funds and exchange-traded funds representing every market niche--and doing it are two different things. Theory and practice often diverge. I see little in the past data that suggests, prima facie, that investors will be able to successfully time moves among all the new and increasingly esoteric index vehicles at their disposal.

It may be that a well-chosen mix of a few core index funds remains the best recipe for long-term success because it's something investors will stick with. Only time will tell.

The Final Bell
It's time to put the gloves down and accept that there's value to both active and index approaches. A number of actively managed funds have beaten the broad market, but index funds tracking the market still delivered solid returns over time in a cheap, low-maintenance package that's a perfect fit for many investors. Meanwhile, those willing to roll up their sleeves and do a little fundamental research appear to have a good chance of picking winning active funds. Of course, many investors have successfully mixed both types of funds for years. Some use index funds to gain cheap exposure to core areas, such as large caps where the data shows that many managers don't distinguish themselves from their benchmarks, while picking active managers in less-efficient areas of the market, such as small value.

Maybe it's time for the rest of us to start thinking of it as active and passive, not active or passive.

Michael Breen does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.