Morningstar Advisor - February/March 2013 - (Page 36)

Spotlight Yes, There Are Good Active Funds By Daniel Culloton The average active fund is a loser. So, don’t buy the average active fund. Statistical portraits of the average American are often unflattering. The numbers usually describe the typical Yank as an overweight coach potato who consumes too many Quarter Pounders and sugary drinks. “Basically,” my daughter quipped after reading such a description, “the average American is gross.” A Hopeless Case? Yet, even indexing adherents disagree whether passive investing is an all-or-nothing proposition. Last year, I attended an event held in honor of Vanguard founder Jack Bogle by the Institute for The Fiduciary Standard in New York. Naturally, indexing was one of the main topics of discussion. Roger Ibbotson, the Yale professor and founder of Ibbotson Associates; Burton Malkiel, author of A Random Walk Down Wall Street; Gus Sauter, Vanguard’s outgoing CIO and former index fund manager; and even David Swensen, Yale’s very active endowment manager, all agreed on indexing’s central tenets and attractions. It’s easy to come to a similar conclusion about active money managers. Studies by Morningstar and others of the performance of the typical actively managed fund versus relevant benchmarks often show the active fund losing. The theories explaining indexing’s advantage are well known. Because professional managers make up most of the market, on average, they can’t beat the market, on average, after they deduct their fees. So, low-cost indexing is bound to beat the typical active manager. Even the managers who manage to beat their bogies in one time period will find it darn near impossible to do so in subsequent time spans. The only issue on which they differed was whether indexing, which now accounts for about one fourth of mutual fund and ETF assets, should completely dominate investors’ portfolios. That’s when a difference emerged, and I thought about my child’s revulsion of the average American. This has not gone unnoticed. In recent years, investors have pulled hundreds of billions of dollars from actively managed domesticstock funds and poured a comparable sum into traditional and exchange-traded passive funds. To the extent that the cash has gone toward building balanced portfolios of cheap, broadly diversified stock and bond index funds, it has been smart money. Sauter, the veteran index fund manager from the firm that did for passive investing what McDonald’s did for the hamburger, actually conceded that active management was not a hopeless case. It’s possible for some active managers to beat the market, Sauter said, though it’s so hard to pick them beforehand that investors should still index a big portion of their assets just in case. 36 Morningstar Advisor February/March 2013 Swensen, the highly active endowment manager whose success and writings have inspired a generation of institutional investors to add alternative strategies and asset classes to their portfolios, said it was either all or nothing when it came to active and passive investing. If you can’t bring the same kind of time, expertise, and resources Yale does to bear on the task of selecting managers, don’t bother, he said. Just index everything. “There’s almost no chance that you’re going to pick an active fund that’s going to beat the market over a 20-year period,” he said. Bad Managers vs. Bad Behavior Even if you are a self-possessed investor, is it worth the bother looking for consistently above-average managers? Arguments against active management often rest on studies that pit the returns of the average manager against a specific index or series of benchmarks, such as the S&P 500 or its growth, value, and market-cap cousins. These studies have encouraged the exodus to passive vehicles but also have shortcomings. Some benchmarks aren’t a good fit for the funds in the categories they try to represent, and the fees and transaction costs that drag on active managers’ results don’t hinder the benchmarks. To circumvent some of these problems, I looked at the performance of actively managed domestic-stock funds versus relevant passive

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2013

Morningstar Advisor - February/March 2013
Letter From the Editor
Social Media, the Old- Fashioned Way
Do You Use Active Strategies?
Youth Appeal
How to Buy the Unloved 2013
Morningstar Managers of the Year
Investments á la Carte
Investment Briefs
Approaches to Absolute-Return Investing
In Agriculture, It’s Good to Be Strong
Yes, There Are Good Active Funds
The Decoupling
Where It Could Pay to Be Active
The Active Fund That Defies Obsolescence
The Epitome of an Active Manager
Lines of Communication
The Existence of Market Timing ‘Intelligence’
A Route to Commodities that Bypasses the Futures Market
Best Positioned for Health-Care Reform
Diversified Stock Funds That Earn Their Stars
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
A Twisted Debate

Morningstar Advisor - February/March 2013