Morningstar Advisor - December/January 2012 - (Page 66)
Exhibit 1 Index Funds Thrive With Strong Asset Classes: Index performance varied with style-box asset-class performance.
Style-Box Asset Class Relative Performance of Index vs. Funds in Style-Box Asset Class
toe-to-toe with the costless S&P 500—an ironic showing, given that the Oughts were the decade in which the alleged “failure” of active management demonstrated to many onlookers the superiority of the passive approach. However, those same funds trailed both the Russell 1000 and Wilshire 5000 indexes. Again, hit or miss? With these examples, the benchmarks that outgained the funds (the BarCap U.S. Govt/ Credit 5–10 Year, Russell 1000, and Wilshire 5000 indexes) are probably better fits for the two categories than are the more-famous benchmarks that lagged. Nonetheless, it’s tough to argue that actively managed funds got beaten. After all, nearly everyone entering the 21st century would have agreed that the familiar S&P 500 and Lehman Aggregate indexes would have been the appropriate indexes for those categories—particularly because those indexes were the ones that had been converted into large mutual funds. Thus, it’s a fair argument to state that for the decade, the active funds won, and the passive funds lost.
The Better Path
definition a fund will struggle to keep pace with the index if the asset class finishes first over the time period. Conversely, it takes a specially incompetent or unfortunate fund not to beat the index of the last-place asset class. An example may be seen in Exhibit 1. The x axis shows the relative performance of the nine sections of the Morningstar Style Box, expressed in terms of annualized performance for the trailing 10-year period through Sept. 30, 2011. Thus, a figure of 3.00 would indicate that the style was highly successful, beating the U.S. stock averages by 300 basis points per year. The y axis shows how the style index fared versus funds. For the seven categories that had positive numbers, the index outgained the average fund. With the remaining two categories, the funds were the better performers. Three areas in which indexing might fail are in markets that have bubbles, are narrow and specialized, or are illiquid. An example of the first would be the aforementioned market-cap global indexes in the 1980s, which were distorted by the extraordinarily high prices assigned to Japanese stocks. Many country indexes fall into the second category, such as the Finnish market, long dominated by the single stock of Nokia NOK. Finally, because of infrequent trading of the underlying assets, indexes of lower-quality muni bonds tend to be theoretical rather than practical constructions. That indexing might fail in such markets doesn’t mean that it will. There will always be market conditions and time periods that favor passive strategies, even in the areas that seem least suited to be indexed. However, in these markets indexing is no longer an automatic tactic; even avid passive-management advocates will need to pause, evaluate the specific situation, and make certain that the available index works for them. K
John Rekenthaler is Morningstar’s vice president of research.
2.0 1.5 1.0 0.5 0.0 –0.5 –1.0 –1.5 –5.0 –4.0 –3.0 –2.0 –1.0 0.0 1.0 2.0 3.0
Relative Performance of Style-Box Asset Class vs. Stock Averages Data as of Sept. 30, 2011. Performance based on trailing 10 years.
excellent. For the decade, three fourths of mutual fund categories outgained the consultant’s composite index. (Yes, these calculations account for survivorship bias among funds.) The study faded into obscurity; there was no follow-up.
The Benchmark Choice
Exacerbating the difficulty is that there are several reasonable benchmarks for most mutual fund categories. As the benchmarks can differ substantially in performance, so choosing one versus another necessarily colors the results. Over the 10 years through Dec. 31, 2010, adjusted for survivorship bias, intermediatebond mutual fund managers have, on an assetweighted basis, outlegged their prospectus benchmark: the BarCap Aggregate. Hey, terrific! But they have lagged the benchmark used by Morningstar to measure their category, the BarCap U.S. Govt/Credit 5–10 Year Index, by 60 basis points per year. Oh, bad! Similarly, over the same time period and using the same methodology, large-blend funds went
Given the frequent mismatch of benchmark and fund attributes and the availability of multiple benchmarks, speculating about where portfolio managers might be able to add value and where they cannot looks to be a mug’s game. Yes, people engage in such exercises, but simply examining a different time period or selecting an alternate index would likely change their conclusions. It makes more sense to avoid the question altogether. The reality is that the market conditions largely drive the conclusions. As a general rule, indexes of booming asset classes outgain funds of that category, and indexes of losing asset classes get beaten by the funds. This phenomenon is frequently attributed to managers holding cash, but the principle that passive management fares best with bullmarket assets is broader than that. Few active mutual funds have as pure an exposure to a given asset class as does an index, so by
66 Morningstar Advisor December/January 2012
Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012
Morningstar Advisor - December/January 2012
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere
Morningstar Advisor - December/January 2012