Morningstar Magazine - October/November 2016 - 12

Dispatches Where Does Active Management Fare Best? No matter what your answer, you will be right-and wrong. I VO RY TO W E R S John Rekenthaler Almost every mutual fund Morningstar Category offers the choice of actively or passively managed funds. Presumably, some categories are better suited for active management than others. What's an investor to do? Where should active funds be used, and where should they not? Many articles have attempted to answer those questions. Some are based on intuition: "Index in Category A because its marketplace is efficient, but consider investing actively in Category B because its sector is less efficient." Those claims can be discarded. Instinct may work for affairs of the heart, but it is of no use for investing. Articles that rely on evidence, by running the numbers, would seem to be on firmer ground. However, with this particular topic, the data rest on sand. That sounds sensible. Unfortunately, there is a very large catch, because a category's success ratio depends upon another factor. The ratio is affected by relative performance-that is, by how the category's total returns during the study's time period compare with the returns of other, related categories. Strong category performance hurts active management's score, while weak category performance helps active management. performance. As is customary with X-axes, the weakest numbers are plotted on the left, the strongest on the right. I will restate the matter more simply. By definition, indexes are 100% devoted to their investment categories. They don't have cash, and they don't hold securities from other investment styles. They offer the pure category experience. Thus, when a category leads the performance charts, the index funds typically outdo their more-diluted actively managed rivals. And vice versa. The best way to interpret the chart is to consider its four corners. 1,000 Words A picture will be clearer yet. E X H I B I T 1 shows the nine diversified U.S.-stock fund categories (that is, the nine Morningstar Style Box squares) for various rolling five-year periods. The Y-axis measures that category's success ratio, ranging from less than 10% for the worst results for active management (yikes!) to near 80% for the best. The X-axis shows the category's relative (If your memories of college statistics have grown fuzzy, z-scores are nothing fancy. They are merely a way of standardizing results, so we can fairly compare performances from volatile time periods to those of stable periods.) The top left represents categories that had terrible relative performance and excellent results from active managers. Those who owned a fund from that category, during that particular time period, would likely be disappointed. The fund was a member of a lagging group-the worst sector of the U.S. stock market. But there was a silver lining for those who held an actively run fund, as it likely outperformed the index. The bottom right corner represents the flip side of that situation. Those categories pleased their owners by turning in outstanding relative performance. However, the shareholders were not entirely pleased if they owned an actively EXHIBIT 1 U.S. Equity Categories: Success Ratios vs. Relative Performance Funds Morningstar Category Average Success Ratio (%) 80 60 Good in Theory Here is why. The natural approach when running the numbers is to sort fund categories by their funds' success ratios. That is, for a given time period, calculate what percentage of each category's funds beat a relevant investment index (for example, small-value funds would be compared with a small-value index). Consider investing actively in categories that have high success ratios-say, exceeding 60%. Conversely, the prudent course is to index in categories that have low success ratios. 12 Morningstar October/November 2016 40 20 -2.5 -2.0 Z-Score Source: Morningstar. -1.5 -1.0 -0.5 0.0 +0.5 +1.0 +1.5 +2.0 +2.5 0

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016